At some point, everyone works hard for their money. The key to building wealth is to make your money work hard for you.
This is also called investing, one of the key pillars of personal finance.
So how do you decide what to invest in when there are so many options? There are three criteria that I like to use when evaluating potential investments:
How risky is it?
There’s no such thing as a risk free investment. But there’s a wide range among different investments in terms of how risky they really are.
For me, the key question is this: How likely are you to lose all your money? There are other forms of risk, but none as important as the worst case scenario.
A good investment has a low chance of losing everything. This is one of the key features that distinguishes investing from gambling.
How high are the potential returns?
One incredibly safe investment would be to put your money in a savings account. The problem is that the returns will be awful.
Interest rates at typical banks are well below 1% per year (and I mean well below). When you’re with an online bank like Ally, your rate (at the time I’m writing this) is less than 2%.
Those kinds of rates just aren’t going to cut it.
Historically, interest has averaged a little over two percent per year. This year it has been way more than that.
If your investment can’t beat inflation, it looks like you are getting richer when you’re actually getting poorer. Think about it: It doesn’t matter if you double your money if everything costs three times as much.
The more your investment can return per year, the better. Personally, I view a good investment as being able to return 7% per year. It’s a bit of an arbitrary standard, but that’s how much of a return you need for your money to double every 10 years:
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How passive is it?
Some investments are pretty much set it, and forget it.
Others require continuing work.
Obviously if we have a choice, we’d prefer the former to the latter. But sometimes there is the potential to make more money by being a little more active in your investments.
Applying the Three Criteria to “The Millionaire Makers”
There are countless ways to become a millionaire. But really, there are only three that have the time-tested ability to turn regular people into millionaires:
- Starting a business
- Real estate
- The stock market
Yes, the lotto has made some people millionaires. So has professional sports. Ditto for crypto. But those aren’t reliable methods for regular people. They’re much sexier than what we’re going to talk about, but they are way less likely to work for you.
And this post is about how to make your money work for you.
So let’s break down each of the three. I’ve also gone over these three stalwarts in a previous post:
Starting a Business
Starting a business is risky. You could easily lose every dollar that you put into it. Worse, you could lose more than you put in. This would happen if you borrowed money to help fund your business and found yourself unable to generate enough revenue to pay it back.
So why did I put it in the middle of the road in terms of risk? Because there are ways to manage your financial risk. One way is by bootstrapping. This just means that you invest the money you make from sales back into the business instead of taking out a loan to grow. Of course, there’s still the risk that you’ll lose whatever you put in.
But this highlights one of the major differences between starting a business and the other two methods: The ability to use “sweat equity” to substitute for actual investment dollars. In other words, if you’re willing to work hard enough, you can get away with putting a lot less money into your business.
This can be a good or a bad thing, depending on how you value your time and what kind of return you get.
Overall, the risk is highest for starting a business because it’s the most likely investment where you could see the value of your asset go to zero.
This is the area where starting a business really shines.
Your returns are essentially unlimited. It might not be likely, but it’s possible to start a business that makes millions of dollars in profit every year. Your company could sell to a tech giant for nearly 20 billion dollars.
If returns are the area where starting a business really crushes it, passivity is the area where it gets crushed.
The problem is that it takes a ton of work to get a business up and running. And it can be super stressful. But if you don’t mind putting in a lot of work with a higher level of risk, you expose yourself to the biggest rewards.
It’s possible that eventually you can build a business that you can sell or that can operate without you, but it will take a lot of work to get to that point.
There are a lot of little risks in real estate:
- You might not find tenants
- They might not pay their rent on time
- There could be more maintenance and upkeep than you expected
- You could struggle to keep up on your mortgage repayment
But there is a major mitigating factor to the risks: You own a valuable asset that is unlikely to lose all of its value. This isn’t foolproof protection however. If you are forced to sell the property for less than what you owe on the mortgage, you’ll lose more than your initial investment.
So why did I put real estate as being lower risk than starting a business?
- The value of a property is unlikely to ever fall to zero, the value of a business is
- It’s much easier to start generating revenue with real estate, just find someone to rent your property
Historically, the returns on real estate have been pretty similar to stocks.
But skill is a differentiating factor here. If you can be smart about your real estate investments you can definitely out earn the stock market.
A lot of this has to do with keeping your overall costs down, but most of it has to do with the single biggest expense: The cost of the property. As they say, money is made in real estate when you buy, not when you sell.
It’s definitely nowhere near as passive as investing in the stock market. At it’s worst, it can be just as active as starting a business.
You can let a leasing company manage your property for you, but they will eat up a chink of your returns. Alternatively, you could get the point where you have enough properties bringing in enough money that you hire a property manager to take care of things for you.
But overall, this is an investment that scores low on passivity.
The Stock Market
Investing in individual stocks can be super risky. Investing in the whole market (such as with total stock market index funds) is far less risky.
Remember, the most important risk in investing is the risk that you’ll lose everything. If you invest in an index fund that tracks the whole stock market, can you lose everything? Only if every publicly traded company in America goes under all at once. Is that possible? Anything is possible. Is it likely? No.
And actually, even if every publicly traded company in America went bankrupt at the same time, you probably wouldn’t lose everything. The companies would liquidate their assets, pay off any debt they have, then return the rest to the shareholders.
When you have a passive investment strategy that uses index funds, the biggest risk is something called sequence of returns risk. This is the idea that sometimes the market goes up and sometimes it goes down. Even though it usually goes up, the timing can really bite you once you start taking money out.
For a deep dive on sequence of returns risk and its antidote (asset allocation), check out this post:
The S&P 500, the most popular benchmark of stock market performance, has returned an annualized average of about 10.5% since its inception in 1957. That’s not half bad.
Obviously the market goes up some years and down others. What we mean by an annualized rate is that if you’ve had money in the stock market since 1957, the amount you have now is the same as if you had been getting a 10.5% annual return.
By the way, a 10.5% return leads to your money doubling once every seven years:
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So while there are some risks with timing like we saw in the last section, the overall returns of the stock market have easily cleared our 7% benchmark over a very long span of time.
Although of the three millionaire makers, this one is the one that returns the least.
I think this is the area where the stock market shines the most.
Passive investing with index funds is about as close as you can get to a system where you can set it, and forget it.
Once you decide on your initial asset allocation, you can set up automatic investments through Fidelity or Vanguard or whatever company you invest through. From that point on, it’s probably better if you don’t mess with it.
You might need to check in on your money every now and then to make a withdrawal or to rebalance your portfolio, but things will mostly just run themselves without you.
This is the main reason why I think that the stock market is so great. If you don’t know how to make your money work for you, you can at least pick an investment that doesn’t take long to learn the basics of and will run on autopilot once you set it up.
Thanks to inflation, any money that you save is working against you. While it’s a good idea to have an emergency fund, the money inside it is losing purchasing power every year. The only way to get ahead is to learn how to make your money work for you.
It’s hard to get rich by saving. It’s much easier to build wealth when the money you save makes its own money.
Featured image credit: Andrew Magill from Boulder, USA, CC BY 2.0 https://creativecommons.org/licenses/by/2.0, via Wikimedia Commons