Empowerment Journey Step 7

The key to financial freedom is combining your personal earning power (your unique skills leveraged into a career) with a well-managed investment portfolio that grows while you sleep. The next step on our journey of empowerment is investing, so let’s discuss why it’s important along with the main types of investments for wealth-building.

Important Disclaimer: I don’t know you or your financial situation, so nothing in this post, or on this site, should be taken as investment advice. You should always do your own research or work with an advisor who understands your entire financial situation. Investing involves risks including the loss of your investment.

It’s Tough to Work & Save Your Way to Wealth

We’ve previously talked about how having an emergency fund to cover unforeseen event provides security, like a moat around your financial castle. For some people, that’s enough. They don’t accumulate debt, and have enough in savings that if they lose their job, they’re ok. Someone with a lot of savings can afford things they unexpectedly want or need. They know how much it costs vs. how much they have.

Those with real wealth can pay less attention to the numbers and more attention to the experiences they have. They’ve grown their numbers to the point they don’t need to track them on a daily basis. They’re financially bulletproof. I want to be wealthy and I want it for you as well.

Even if you earn a high salary and save money, it’s difficult to accumulate wealth because inflation erodes the purchasing power of money over time, as illustrated in the chart below from Visual Capitalist. This is a huge obstacle to wealth-building.

Checking and savings accounts are designed to provide stability of value, not growth. If you have $100 in your Wells Fargo account today and don’t spend anything, you expect to have $100 there tomorrow. Even if you’re earning a decent rate on your savings, it will struggle to match the inflation rate over time. The chart below from the St. Louis Fed shows the Federal Funds rate minus the inflation rate, measured by CPI. Federal funds is the overnight rate at which banks lend to each other, and is a good proxy for very short-term rates such as those offered on short-term savings (money-market funds, CDs, etc). Going back to 1954 (as far back as the data goes), the short-term market rate averaged 1% above the inflation rate (the red line) at any given time. That’s better than stuffing money under your mattress, but a 1% return probably won’t make you wealthy.

To build real wealth you have to get that force of nature – compound interest – working in your favor. It’s time to start investing.

Investing Has Beat Inflation For > 200 Years

Investing has been the most potent way to grow wealth over and above the rate of inflation over time. The chart below from Jeremy Siegel’s Stocks for the Long Run, shows the value of $1 invested in various assets, after the effects of inflation, with data going back to the 1800s. The dollar (money under the mattress) lost value after inflation, which we already knew from the charts above, while investments in stocks significantly outpaced inflation. Bonds and bills (very short-term, cash-like instruments) did ok, and gold struggled to match inflation over that period.

This long-term data on stocks and bonds from Ibbotson Associates shows nominal returns (i.e. not including inflation) and plots inflation within the chart for reference. It likewise shows that stocks significantly outpaced inflation, bonds and bills less so.

According to Investopedia, the average annual return for the S&P 500 – a broad index of US stock prices – since its inception in 1928 has been roughly 10% (the Ibbotson chart likewise shows annual returns of 10% for large cap stocks). Compare this to the average inflation rate from 1948 through July 2023 of 3.5% according to the St. Louis Fed and you can see that stocks have historically provided significant growth above the rate of inflation. If you want to protect against inflation, stock ownership is a powerful way to do so.

Stocks = Ownership

Stocks (sometimes referred to as “equities”) are issued in shares to fund the operations of businesses. In exchange, shareholders have ownership interests in the business. Recall in step one that businesses earn profits by providing valuable goods and services to people. Successful businesses continuously innovate and increase the value they provide over time. While not every business is successful, the markets broadly speaking have grown over time as unsuccessful businesses are out-competed by newcomers with superior products/services people want and are willing to pay for. My parents wanted a higher standard of living for me than what they had, and many people similarly want to improve their quality of life over time. Businesses seek to meet these desires and turn a profit in doing so, and stock investors are entitled to share in those profits.

If you own 100 shares of Wal-Mart stock, you are part owner in the company and entitled to a portion of their future profits (if there are any). Stockholders may have voting rights which allow them input on choosing who sits on the board of directors and other management issues. Management teams are incentivized to keep stockholders happy or they can lose their jobs. Many companies pay dividends which come out of their profits, as a way of “making good” on their commitment to shareholders. If they can grow profits over time, they will often also increase dividends to keep investors happy. But even if they don’t pay dividends, increasing the competitive position of the firm tends to increase the stock price, which benefits shareholders.

Businesses face competition which causes profits to fluctuate. A company may lose money at first, but become profitable down the road. If times are tough, the company doesn’t have to give stockholders anything, i.e. dividends can be cut. It’s hard to foresee how fluctuating business environment will affect individual companies, which is one reason stocks tend to be risky investments. Many companies fail, and in the event the company goes bankrupt, shareholders are last in line to get paid, behind bondholders and other creditors. This means that stocks are more risky than bonds, and it’s why investors generally expect higher returns from stocks.

Stocks are the engines of growth; the more you have, the more growth you should expect over time, and also the more the value of your portfolio will likely fluctuate. The longer your timeframe for investment – the longer before you will need to start taking withdrawals – usually implies that you can tolerate more fluctuations in pursuit of higher growth. If your aim is to build wealth, and time is on your side, it’s often appropriate to have the majority of your portfolio in stocks. But everyone is different, and you need to consider your own attitude toward risk before investing.

Bonds = Debt

Bonds are a contractual obligation between the issuer (usually a company or government) and investors. If you own bonds issued by a corporation, they are required to make regular payments to you in the manner described in the indenture, or governing document. Bonds are someone else’s debt that you get paid to hold.

Unlike stocks, the interest payments on bonds must be paid. By issuing a bond, the company or government creates a legal obligation. If the issuer defaults on the bond, it will make it difficult for them to borrow money in the future; their credit rating will go down, investors who lost money will shun them, and their reputation will be tarnished. This is why bonds tend to be less risky than stocks; their returns depend less on the overall business environment, and payments are required regardless of what happens (recession, wars, etc).

Unlike stocks, bonds do not entitle investors to the future profits of the issuer, only the stated interest/principal payments. This is why bonds are also referred to as “fixed income” (the amount you get is fixed). If Wal-Mart has a great quarter and increases profits, their stock price may go up, or they may increase their dividends to stockholders. However, this would have little effect on holders of Wal-Mart’s bonds, because their fortunes don’t change regardless of how good/bad Wal-Mart’s business is going.

The main things that influence bond prices are interest rates and the credit quality of the issuer. If market interest rates rise, bonds issued at the prior (low) rates tend to fall in value, because their fixed payments at the lower rate are now less attractive. Conversely, as rates fall, bonds issued at prior (higher) rates appreciate because their fixed payments represent a premium vs. what is now available.

Credit risk tends to be a yes/no question; can the issuer afford the debt payments? If so, bondholders are generally happy. If the issuer goes bankrupt, because of their contractual nature, bondholders have priority over stockholders in a liquidation and may still get paid. This is another differentiating aspect of bonds versus equities (stockholders typically lose their investment in that scenario).

The general lower risk of bonds relative to stocks makes them a natural complement in portfolios. To the extent you are hesitant to take stock market risk, or the closer you are to needing to access your investment dollars (if you are nearing retirement age for example), increasing the amount of bonds in your portfolio should help reduce the amount of fluctuation you experience. This is exactly the strategy behind target date funds, which shift their allocation from stocks to bonds as the investor ages.

Bonds don’t eliminate risk – they can go down if market rates increase or the issuer defaults, and their fixed payments are vulnerable to being eaten away by inflation over time. But bonds are a good tool to manage equity risk in a portfolio.

Other Types of Investments

Real estate is a common investment used to build wealth. People invest in real estate by buying individual properties but that’s expensive and it can be hard to get your money out of such transactions (they are “illiquid” in finance terms). Real Estate Investment Trusts (REITs) are a more streamlined way to invest in real estate. REITs are equity securities that purchase multiple properties on behalf of their shareholders. Many REITs trade on exchanges like stocks, and tend to offer attractive income, because they receive tax-advantaged treatment from the IRS if they pass on a certain amount of income from their underlying properties to shareholders.

Infrastructure refers to investments in companies that own/operate physical assets like utilities, railroads, airports, and pipelines. Infrastructure investments may be less volatile than stocks during periods of market stress since their revenues may be less sensitive to the business cycle.

Commodities are the physical inputs required to produce goods and services. There are numerous types including energy (oil, natural gas, etc), metals (gold, copper, aluminum, lithium), and agricultural or “soft” commodities (coffee, soybeans, livestock). Because they have a fixed supply, commodity prices are often the first area where unexpected inflation is felt; thus they can offer inflation sensitivity. Additionally, since commodities markets are driven primarily by serendipitous supply/demand events like weather and discovery of new deposits, they tend not to move in-line with traditional stock and bond investments.

Don’t worry about these other types of investments if you’re new to investing. Even for larger portfolios, an allocation of around 10% of the total portfolio is usually plenty.

Investments vs. Speculation

For most investors it’s appropriate for the majority (95%+) of your portfolio to be some mix of stocks, bonds, and other investments. But beware; some things portrayed as investments are actually forms of speculation.

Investing and speculation are not the same thing. Investing involves broad market risk that has compensated investors for hundreds of years (competition, the business cycle, etc) – see the graph above. Diversified investment funds – mutual funds and exchange-traded funds (ETFs) hold “baskets” of stocks and bonds. Some funds hold hundreds, even thousands, of securities, so the risk that any single issuer failing impacts your portfolio is reduced (but not eliminated). These are the types of investments to start with, and I’ll discuss examples and ideas for building a basic portfolio in a different post.

Speculating involves taking narrow risk that a certain company/technology will prevail.

Speculation usually involves betting on something that is unproven, often some type of new technology, or something that requires a certain regulatory outcome to be profitable. Current examples are cryptocurrencies or AI-related startups. Examples from history include internet stocks in 2000, marijuana stocks in the 2010s, or railroads in the 1800s.

New technologies come and go every year. Some change our lives forever, some don’t (I’m old enough to remember BluRay). Even if they do, separating the winners from the losers is not easy. There were tons of “dot-coms” back in 2000, and Amazon, Yahoo!, Google, and Ebay are some of the only survivors. I wonder how many AI stocks will be around 20 years from now?

The tricky part is, speculation can be profitable at times. It’s likely that you’ll eventually meet someone who made money speculating and they’ll make it sound easy. The media will focus on the winners and ignore the many who fail. You’ll feel like a fool for missing out. Remember people want to appear successful in the eyes of others, and to themselves.

Investing isn’t about feelings.

NONE OF THESE ARE NECESSARY FOR YOU TO BUILD WEALTH!

Investing, like other disciplines, has levels and it’s important to understand where you’re at. You can have fun and get a good workout playing basketball without going head-to-head with LeBron. If you try it as a beginner … it will probably hurt.

Investing is Boring

A hallmark of speculation is that … it’s fun! I’m not saying you shouldn’t have fun, just not at the risk of your financial health! Race go-carts, play video games, go rock climbing – those are all fun and none of them will bankrupt you.

Why speculate when there are proven, PROFITABLE companies to invest in? “Normal” equity market risk born out of competition to sell the best product/service and the nature of markets in general has consistently rewarded investors over the last two centuries (see graph above). As a beginner investor, that’s the only risk you should be targeting. Investing done right … is kind of boring.

Think of investing like planting a tree. It’s easy to dig a hole in the ground for a small sapling and plant it, but it needs tending to grow into a mighty oak tree. Regular watering, keeping weeds away, protection from people stepping on it, none of these things take much time to do, but they must be done regularly until the tree is established.

If proper care is given over the first few years, a tree grows deep roots and can survive harsh environments from summer heat to winter’s freeze. You don’t see people watering the 30 foot tree that towers over their house, right? They don’t need to; it sustains itself. With proper care, today’s sapling can grow into a beautiful tree your kids can climb on in 10 or 20 years.

Like watching a tree grow, investing is not that exciting day-by-day. But if done right, it produces strong results. Today’s small investment portfolio, if allowed time for compounding to do its thing, can grow to be mighty. Investments help fund universities that educate people, foundations that pursue philanthropic missions and support the arts and humanities, and pension plans that support people in retirement. Some of these institutions have portfolios that have sustained their operations for decades, even hundreds of years. If it works for them, it can work for you and me.

But it requires patience. The sooner you start, the better.

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