Commandment 2: What Do I Actually Invest In?
This is the second of a ten part series where we look at Haven’s Ten Commandments, a short list of investing fundamentals we like to teach to our clients. It’s nothing too fancy, but a good foundation we believe everyone should understand.
In the first part of our ten part series we looked at the fundamental "Why" behind investing - compound interest. If you haven’t had a chance to read it check it out here. At this point, we know what compound interest is, how it works, and how we can take full advantage of it. But what do we actually invest our money into?
Think of investing like a road trip. There are times when you’re advancing quickly and flowing with traffic - making great time. Other times you’re stuck behind a slowpoke, or even worse, stuck in traffic with nowhere to go. It’s a natural part of driving, you’re not always able to go the speed limit (or above it) at all times. Just like driving, investment markets speed up, slow down and get stuck. It’s all entirely natural. The important thing is to know where you’re going and how you will get there. By planning to leave early and drive efficiently, you can get where you're going on time or early, even if hiccups happen to occur along the way. If you prepare correctly they won’t seem like such a big deal, it’ll all just feel like part of the journey.
Investing, by definition, means sacrificing enjoyment now for a larger amount of joy later. From a financial perspective, this means putting our hard earned money to work instead of immediately spending it. But how is it that we put our money work? This is a great question. In brief, it requires putting our money in places where it can be more productive. Let's explore further.
Practically speaking, your three most common forms of investment are: stocks, real estate and bonds. Each one has its own risk characteristics and each comes with their own return expectations. By buying shares of a company or a fund, you are taking a small ownership in it, and are able to reap the rewards.
Stocks are simply an ownership share in an existing business. They are typically the most volatile form of investment, meaning that they will have the most ups and downs to achieve its overall growth. These ups and downs can be both exciting and terrifying. Since stocks are the most volatile it is also associated with being the most ‘risky’ investment option and therefore allows investors to the largest potential for gains, but also potentially exposes them to largest loses. Usually you can buy individual stocks (or shares) of a company or you can buy stocks of companies through something like an ETF (Exchange-Traded Fund).
Bonds are simply a loan you give to a business or government that pay you a fixed rate of interest. They are often considered the safest or most conservative investment option. This is because bonds are usually issued by governments or big companies and have predetermined rates of return. Because they are more predictable they typically provide lower return potential than stocks. Common ways to invest in bonds are through ETFs or Mutual Funds.
Lastly, real estate is generally seen as somewhere between stocks and bonds. Real estate produces cash flow (provided the rents are higher than the expenses) and also tends to conservatively fluctuate in value. Usually real estate investing is done through ownership of physical property OR you can buy shares of a REIT (Real Estate Investment Trust), who owns and manages real estate to turn a profit.
Below is a generic graph showing volatility between the stocks, real estate and bonds. As you can see, historically over time all three produce positive returns, but short term investing is more risky than long term because every investment has a real risk of negative return in any given year.
A good mixture or recipe of stocks, real estate and bonds will always be important throughout your investing life. Too much towards one of the three could leave you exposed to too much risk at the wrong time, or not exposed enough to higher returns.
It is important to note though that risk and volatility are two different things. Risk is the complete and permanent loss of your investment, whereas volatility is the natural ups and downs that the markets face. These ups and downs can be caused by many different things, Trump tweeting about trade wars, earnings expectations arriving different than expected, new products or mergers being announced. Even the greatest investors see plenty of volatility in their portfolios, in fact, it is often noted that the best investors are the ones who can stay the course in turbulent times.
If you have any questions about investment options or investing in general, we'd love to help you make meaningful progress in your financial life and knowledge.
- Derek Condon, Financial Advisor