I am honored to have a great guest post by newcomer to the Personal Finance Blogging scene: Compounding Works. At Compounding Works, they believe the best investment is in learning, and by compounding it, we will achieve much better financial results.
Using the Pyramid of Wealth Building
The first step to building wealth is to… well, start saving. The savings ladder is a great guide to help you get started. Setting up a budget and save regularly is key to succeed in the long run.
Saving encourages good habits, and protects your future self from both unforeseeable events and planned expenses, such as a wedding, buying a house or retire early.
But just saving isn’t enough, though. If inflation, or the rate at which prices increase over time, continues to rise, your money will loose its value over time, unless you can make it grow faster than inflation rises.
This is where investment comes in. It doesn’t matter if you have $10, $1000, $10,000 or $1,000,000 saved away. If you don’t invest that cash wisely, it will shrink as time goes by and become less valuable.
So how can we invest our cash?
Investing our way to wealth
When it comes to invest your hard-earned cash, the options are endless. From interest accounts, to treasuries, stocks, bonds, real estate, crypto and so forth.
However, should you really consider all of these options? Or should you instead start with a handful and walk your way up the list? If that’s the case, which ones should you start with and why?
Similarly to Maslow’s hierarchy of needs, which describes people’s needs from more basic needs to more acquired emotions, I think we can create an investment hierarchy as well.
That hierarchy would start with the fundamental building blocks of investing, and as we move up, we would consider more sophisticated and riskier forms of investing.
If you’re new to investing, or only have a small amount to start with, you should start at the base of the pyramid, and only move up as you become more knowledgeable and wealthier.
The investment hierarchy
Example asset types: Certificates of Deposit, Treasury Securities, Investment Grade Bonds, Interest accounts
Knowledge needed: Basic
Investment Grade Bonds are those with a rating of AAA, AA, A and BBB. Tools like Yahoo Finance will show you that information for free.
One thing to be aware of, though, is that these investment options have different lock-in periods, so plan your allocation wisely. That way you can make sure you have access to the cash when you need it, without paying any penalty fees.
Example asset types: Stock ETFs that track main indexes, Quality dividend ETFs, Real Estate
Risk: Low to medium
Knowledge needed: Basic to average
At this point, you’re saving consistently, even if just small amounts, and you have sorted out your emergency fund and saving pots. That’s great, so how should you invest the extra cash that comes in?
There are a couple of categories worth considering at this stage. One is investing in good quality ETFs, and another in Real Estate.
Real Estate has a big limitation. You need a significant amount of capital to get started. As an example, if you want to purchase a house worth $100,000, you need a good downpayment of 10% to 20% in order to minimise your monthly expenses. If you can afford that initial investment, then the rent received should cover your mortgage and leave you enough to put aside for repairs and reinvest. At the same time, those renting the property will slowly pay your mortgage, leaving you with a great asset.
Then, there are ETFs. I think there are 2 main category of ETFs to consider:
- Stock ETFs that track the market – examples of these are Vanguard’s Total Stock Market (VTI), or SPDR S&P 500 ETF Trust (SPY). These ETFs track significant portions of the US stock market, which means their output will follow the economic output of the US. Historically, the S&P 500 index has returns an annual average of around 8%, which is great;
- Quality dividend ETFs – in this category of ETFs, we are looking for quality dividends that grow over time. Some individual companies offer large dividends, but their revenues are declining, which isn’t sustainable. By choosing an ETF like ProShares S&P 500 Dividend Aristocrats (NOBL), we ensure that we are only investing in companies that have been consistently growing their dividends. The trick with this option is to re-invest your dividends, letting your wealth compound over time.
The important thing to consider at this level is to choose broader areas of the markets, with a good track record, that closely related to how the economy is performing.
The options mentioned above all provide some sort of cash-flow, either via rent or dividends, which will allow you to reinvest that cash.
Example asset types: Individual Stocks, Commodities, Thematic ETFs, REITs, corporate bonds
Knowledge needed: medium to substantial
From level 2, you learnt about investing in baskets of assets which are relatively stable. That’s great because it allows us to build a strong foundation for our growing wealth.
As you build more and more wealth, you become more comfortable. You know your core savings are protected, and you keep reinvesting your savings into level 2 type assets.
It’s only at that stage that you should consider slightly more riskier options. If you have spare cash and would like to take some risks, there are options for you.
One example is stock picking. In a bull market, like the one we’re experiencing, stock picking sounds quite easy, right? Those that bought Tesla stock at around $200 a share have enjoyed seeing it climbing to $900. But make no mistake – stock picking is one of the hardest things you can do.
Most active fund managers trail the S&P 500 index. But that doesn’t mean you shouldn’t buy stocks that you think will do well in the future.
Commodities are also quite interesting. Gold, in particular, is considered a safe-haven and tends to rise in times of uncertainty. This means it’s an excellent hedge against the stock market.
As you become more knowledgeable, it’s also a good idea to explore thematic ETFs. As an example, if you believe 5G will be the next revolutionary technology in the next 5 to 10 years, you can find out ways of investing in 5G-related companies.
Finally, assets like Real Estate Investment Trusts (REITs) and Corporate Bonds are also worth considering, though some carry significant more risk. Some REITs are limited to certain geographical areas, thus vulnerable to local economies. When it comes to REITs, don’t just look at their dividends, which look very attractive. Instead, consider what real estate they invest in, its location, and how the fundamental data is evolving over time.
Corporate bonds can be quite profitable as well. Some companies, instead of selling more of their stock to raise capital, issue debt and in return pay a good interest rate for it. But, as this is debt, there’s the risk of default, which means choosing which companies to buy bonds from is quite important.
Like any bond, look for their rating before you commit to it. Investment Grade Bonds are the safest, though not risk free when it comes to corporate bonds. Anything below BBB is considered speculative, so the risk of default is quite high.
Example asset types: P2P business loans, Equity Crowdfunding, Private Equity Funds
Knowledge needed: substantial
Moving one more level up in the risk/knowledge ladder, we get to assets like P2P business bonds, equity crowdfunding and private equity funds. Some of these options can be highly profitable, but their risks are also quite high.
Make sure that you’re comfortable in loosing all the money you put into these assets. That doesn’t mean you will loose it, it is just a way to prevent serious financial harm to yourself.
Unlike corporate bonds, which are regulated, P2P business loans are a way for businesses not necessarily listed in any market to raise funds to accomplish certain tasks. Many of the online platforms that offer those do some triage and background checking, but there’s always a risk of default.
Equity crowdfunding is the most accessible way for investors like us to access early-stage startups. All the big corporations we know today have at one point been a tiny startup, so if you’re lucky to invest in the next Google or Amazon, the potential returns can be astronomical. But, 9 in 10 startups do fail, so unless you invest in many, the odds of winning big are slim. But the barrier to entry is almost non-existent. Most platforms allow us to invest amounts as low as $10.
Finally, Private Equity Funds attempt to reduce the risks of equity crowdfunding. They do that by using professional investors to choose which early-stage companies to invest in. That means investors put money into these funds, and then the funds allocate that cash in a large basket of startups, providing more consistent returns.
The downside here is that most funds require a hefty amount to be invested.
Example asset types: Derivatives (options, futures), Collectibles, P2P Lending (individual), Crytocurrencies
Risk: very high
Knowledge needed: expert
At the top of the risk/knowledge pyramid, we have mostly speculative assets. These are assets with highly uncertain returns.
That means there’s no way to predict with any degree of certainty the potential future value. It also means that it’s highly likely their value will go down to zero.
That said, there have been successful stories, especially around cryptocurrencies, that turned people millionaires with little upfront investment.
Furthermore, many traders buy options of futures contracts in the stock market, and generate a return for those. But again, the techniques used are not infallible, so they take up a big risk for a potential big reward.
Collectibles, especially art and wine, do generate a good return. However, it’s important to know in detail what’s worth investing in, and what’s not. If you’re very interested in one of those topics, you can be successful.
Finally, there’s peer-to-peer lending. I put this one in level 5 because most of these loans are unsecured. What that means is that there’s a high probability of default, and if default happens, there’s no asset to protect you against your money. In times of economic expansion, this might be a good investment. However, if a recession happens, the number of defaults will likely skyrocket, leaving a lot of investors empty handed.
Regardless of the types of investments you make, there’s always one thing you need to be aware of. Every time you sell an asset, you will have to pay capital gains tax on the profits.
Sometimes, the taxes are automatically deducted from the profits before you receive the cash back. But there are exceptions to this rule. Plan carefully every time you rebalance your portfolio, and set aside enough money to pay back the taxes you owe, in order to avoid any stress.
In order to build wealth it’s important to think long-term and do it step by step. Jumping steps might work for some that were lucky, but generally speaking, mistakes will be costly.
Let the power of compounding do it’s work. Focus on income-generating assets to start with, and slowly build your portfolio.
As you do that, learn about assets one level above. You might find some that are really interesting to you. Equally, you will find others you would never want to invest in, and that’s fine.
Above all, consider your long term goals and avoid financial decisions that will cause you significant financial harm.
Finally, do remember to take risks, especially when your young, but just be aware of those risks so you’re not caught off guard.