Investments

Invest your money to make more money

rsz_cash_cowWhy is it that successful corporations are continually able to increase their earnings? It’s because they invest their earnings to make more money. You need to do the same. You need to save your money and use it to make more money. Saving money by itself will not lead to financial freedom, saving money and investing it will.

Corporations become rich because they create cash cows. Cash cows are investments that require very little work to maintain and reward their owners with a perennial source of income. You need to adopt the same strategy. You need to invest your money in something that will require very little work on your behalf and will create a reliable stream of growing income. The best way to achieve this goal is to invest your money in a combination of stocks, bonds, and real estate.

 

The stock market

History has proven that, over the long-term, investments in the stock market always go up, even with all the ups and downs along the way. In fact, the compound annual growth rate (CAGR) of the Standard & Poor’s 500 (S&P 500), an American stock market index composed of 500 of the largest companies listed on the New York Stock Exchange (NYSE) or the National Association of Securities Dealers Automated Quotations (NASDAQ) exchange, in the period between Jan 1, 2004 and Jan 1, 2015 has been roughly 8% per year (assuming reinvestment of dividends). Even with the financial crisis in 2008, if you had been invested in the S&P 500 over this time period, you would have earned an average return of 8% a year. The CAGR generated by the S&P 500 over the 30 year period between Jan 1, 1985 and Jan 1, 2015 is 11.4% per year (again, assuming reinvestment of all dividends).

Is this growth going to stop? Not likely. The S&P 500 has been growing for centuries. The idea that the corporations that make up this index are going to somehow suddenly stop making money is not realistic.

That’s not to say that everybody that invests in the stock market will benefit from this continued growth of profits. The problem many investors face when they invest in the stock market is that they become greedy, fearful, and irrational. They invest in companies just because their stock price has risen in the past, they sell good companies just because these companies experience a temporary drop in their stock price, they don’t diversify, and they act as speculators and not investors. All of this behaviour means many individual investor never benefit from the incredible wealth building potential the stock market has to offer.

The key to generating wealth in the stock market is to adopt a proven investment strategy and to stick with it. Two proven wealth building strategies that have consistently delivered positive long-term returns are (1) index investing and (2) dividend investing. These are the strategies my wife and I used to build our financial freedom fund and leave the rat race in our mid-thirties. I discuss these two strategies in great detail in my book, Think Like a CEO and Get Rich, and summarize them below.

 

Index investing

In his book, The Millionaire Teacher, Andrew Hallam details how he became a millionaire on a teacher’s salary by saving his money and investing it in low cost index funds. This strategy is easy to implement with a self-directed online investment account and simply involves holding the same securities in your portfolio as a stock market index such as the DJIA, the S&P/TSX Composite, or the S&P 500. This can easily be accomplished by purchasing either mutual funds or ETFs designed specifically for this purpose.

 

Dividend investing

Dividend investing focuses on investing in companies with a history of consistent and growing dividend payments. This strategy is an active strategy that, generally speaking, involves buying larger blue chip companies that pay investors increasing dividends and have reliable, increasing earnings. Buying companies that continually increase their earnings and their dividends is a good way to ensure you are investing in good companies and not speculating in bad ones.

One of the best ways to implement this strategy would be to buy an ETF that tracks the S&P Dividend Aristocrats Index. The S&P Dividend Aristocrat Index is made up of companies in the S&P 500 index that have a 25 year continuous history of raising dividends. What’s more, by the end of 2014, the S&P Dividend Aristocrats Index boasted a five-year total average annual return of 17.5% and a ten-year total average annual return of 10.5%. These returns compare to five-year and ten-year returns of 14.4% and 7.6%, respectively, for the S&P 500 index.

 

Investing in real estate

rsz_real estateThe other investment that fits your investment strategy of creating cash cows is investing in real estate. Real estate has long been a favourite way for both corporations and individual investors to generate wealth. Just like it has done for corporations, real estate investing can make you wealthy too. It can do so because real estate forces you to save and invest your money and it forces you to use leverage.

 

Forced savings

If you buy a property and rent it out, you almost always need to use the rent to pay the mortgage on this investment property. Chances are, if you didn’t have the mortgage looming over you, this rental income would simply get spent on frivolous items that did nothing to increase your wealth. Therefore, owning an investment property forces you to save and invest money.

 

Leverage

One of the keys to becoming financially free at a young age is leverage. Leverage means borrowing money to invest, and investments in real estate almost always involve the use of leverage. Unless you have a large amount of money lying around, chances are the only way you can buy an investment property is to borrow money and get a mortgage. If used properly, leverage is able to amplify investment gains, as illustrated by the example below:

Let’s assume an investor purchases an investment property for $100,000, pays $20,000 for the down payment, and then borrows the other $80,000 in the form of a mortgage. If, after a year, the investment property goes up in price by 5%, then, assuming the rent covered all the expenses associated with the property (mortgage payments, insurance, taxes…etc.), this investment would have generated a profit of $5,000 (5% of $100,000).

On the other hand, if this same investor were to have simply invested her $20,000 in the stock market and earned an equivalent return of 5%, again after one year, she would have only generated a profit of $1,000 (5% of $20,000). Borrowing to invest resulted in a return that was five times larger than not borrowing to invest. This is true even though both investments increased by 5%. In fact, by borrowing to invest in the investment property, the investor didn’t only earn 5%, she actually earned a return of 25% ($5,000 return on $20,000 invested).

It is important to realize, however, that leverage doesn’t only offer the possibility to generate higher returns; it also comes with the risk of suffering much larger losses. If, for example, the real estate investment mentioned above had dropped in price by 5%, then the investor would not have lost $1,000 (5% of $20,000), she would have actually lost $5,000 (5% of $100,000). This would translate into a loss of not 5%, but a loss of 25% ($5,000 loss on $20,000 invested). It is because of the larger variation in returns, including the possibility for much larger losses, that leverage is always considered riskier than no leverage at all.

 

How to invest in real estate

Their are plenty of things to consider in order to make a good real estate investment. Some of these things include the supply and demand of the type of real estate in question, the availability of good tenants, vacancy rates, and the possibility to earn positive cash flow from your investment while you wait. I discuss the strategies my wife and I used to purchase our investment properties in greater detail in my book.

Whether it’s investing in the stock market or investing in real estate one of the keys to achieving financial freedom is making sure you properly manage risk. Click on the link below to read more.

 

Risk