The Three Purposes of Investing
By Steve Gillman - July 6, 2013
Let's start with the three purposes up front. When we invest
we want to do one of the following:
1. Generate income.
2. Have the investment grow in value.
3. Preserve capital.
Recent years make it clear that one of the reasons to invest
is to simply stay even; to preserve what you have. You would
probably love to accomplish the first or second purposes, which
both involve making money with your money. But in a time when
all investments seem a little uncertain to say the least, and
the currency is possibly being destroyed by a massive printing
of dollars, you may mostly just want to preserve what you have
saved. And if you stick that money under a mattress it might
be eaten up by inflation. If in ten years or so you end up with
a dollar that is worth half of what is worth now, you need to
have doubled your money just to stay even, to buy the same number
of loaves of bread or the same car or whatever. One way to preserve
that buying power is to invest in things that hold value as the
currency is devalued. Traditionally these "stores of wealth"
include gold and other precious metals as well as real estate.
Preserving Capital
The promoters of gold remind us that it has never gone to
zero and that it has retained its value over the long run, Unfortunately
that "long run" that can be a lot of years. It may
be true that an ounce of gold will buy roughly the same amount
of wheat or house as it did two hundred years ago, but what if
you bought your gold in 1980 at around $800 per ounce. It would
have been over 25 years before you got back to even - without
accounting for inflation. In fact, as of June 2013 gold is at
about $1,300 per ounce, and a gain of $500 per ounce is a lousy
return for a period of 33 years.
Consider if you had simply put your money in the bank and
averaged a 4% return since 1980 (possible given the 10% CDs available
at the start of this stretch). $80 would have grown to over $2,900
by now, more than double what the price of gold has done.
Gold (and raw land) may hold value better than most things,
but for both it is still a matter of timing. This is because
the "market," meaning people, overreact at either end
of troubled times. They rush into gold, driving the price too
high too fast, and then when things seem stable again, they dump
it too fast, driving the price down dramatically. This is true
in many speculative commodities; silver, which went from under
$10 per ounce in 2008 to over $45 in 2010 is trading under $20
per ounce as I write this.
Preserving Capital
The promoters of gold remind us that it has never gone to
zero and that it has retained its value over the long run, Unfortunately
that "long run" that can be a lot of years. It may
be true that an ounce of gold will buy roughly the same amount
of wheat or house as it did two hundred years ago, but what if
you bought your gold in 1980 at around $800 per ounce. It would
have been over 25 years before you got back to even - without
accounting for inflation. In fact, as of June 2013 gold is at
about $1,300 per ounce, and a gain of $500 per ounce is a lousy
return for a period of 33 years.
Consider if you had simply put your money in the bank and
averaged a 4% return since 1980 (possible given the 10% CDs available
at the start of this stretch). $80 would have grown to over $2,900
by now, more than double what the price of gold has done.
Gold (and raw land) may hold value better than most things,
but for both it is still a matter of timing. This is because
the "market," meaning people, overreact at either end
of troubled times. They rush into gold, driving the price too
high too fast, and then when things seem stable again, they dump
it too fast, driving the price down dramatically. This is true
in many speculative commodities; silver, which went from under
$10 per ounce in 2008 to over $45 in 2010 is trading under $20
per ounce as I write this.
One lesson in this might be to buy when these things are still
cheap. Don't take this to mean gold is done climbing. Yes, you
could have bought it at close to $400 per ounce about nine years
ago, but it may still triple from its current price before this
run is over. Predicting the timing and extent of these moves
is next to impossible.
But there is a bigger problem with this kind of "investing."
Gold, silver, and many other speculative commodities don't produce
income. In other words, it is in a sense the same as sticking
the money under your mattress, albeit a hopefully more inflation-resistant
mattress. The goal, unless you have a lot of faith in your timing,
is to do nothing more than preserve what you have in terms of
buying power. In this respect, it may not even be fair to call
this investing.
Consider land, another one of the ultimate "stores of
wealth." Unless you guess well which area that will grow
faster than others and buy at the right time, the best that can
be expected is that when you someday sell for twice what you
bought it for the money will buy the same amount of groceries
and other goods. In fact, since you have to pay property taxes,
if all you do is match inflation, you lose a little each year.
This, then, is at least a way to lose your savings more slowly
than hiding them under the mattress or in a bank account. Not
an inspiring thought.
Here's another less-than-inspiring thought: If you set aside
ten percent of everything you make for 40 years, and all the
"growth" you get in dollar terms is eaten by inflation,
then all this retirement fund does is stay even with inflation.
In other words you have is enough money to pay the bills for
four years (10% of the 40 years). You will almost certainly live
for more than four years after retirement.
Capital Gains
The second purpose of investing is to make capital gains;
to buy things that go up in value. Ideally you want to produce
wealth in this way faster than governments can destroy the value
of the currency that measures it. The stock market may do this
in the long run, but again it can be a long run. The Dow Jones
Industrials Index hit a high of 995 on 2/9/1966. It took almost
seven years to get back to that level, and then it dropped again,
down to 577 by 1974. It wasn't until 1982 that it crossed 1000
for good. It took twenty-six years just to break even.
There is an element of gambling in investing for capital gains.
Again, timing matters. It is true that Warren Buffet (and a few
others) made money in stocks even in bad times, and he didn't
try guessing about the ups and downs of the market. He bought
solid profitable companies that were cheap and held them. Of
course, he has access to boardrooms that you and I don't and
even Mr. Buffet lost tens of billions during the 2008 stock market
wipeout. He also does something that most people are not aware
of. He generates income from his stock portfolio by selling options
on the stocks he owns. He also gets millions in dividend payments
each year. That brings us to the first purpose of investing...
Generating Investment Income
Income is perhaps the safest and most logical goal of investing,
and income-producing real estate may be one of the best ways
to accomplish this. It also will often serve all three purposes;
it can preserve your wealth while providing both income and capital
gains. This kind of investing verges on being a business, though,
since you have to be a landlord or hire one, as well as engage
in other business activities (advertising, going to court to
evict tenants, etc.). I personally didn't like being a landlord,
and I really don't enjoy dealing with real estate, but I can't
help but see the value in it.
Consider a "worst-case" scenario I recently read
about. A man bought a house in Detroit over 30 years ago and
rented it out. He bought it for $50,000 and now has to sell it
for $31,000 because Detroit has been going downhill ever since.
But he only invested about $7,000 of his own money at the start
between the down payment and closing costs, and the rent has
covered the costs over the years. In fact, he owes nothing on
it, so now, in addition to the cash flow over the years his $7,000
has become $28,000 (that's what he clears after the costs of
selling).
Of course, if you buy in an area that is growing and you have
positive cash flow it is more likely that a $50,000 rental house
will be worth $150,000 in 30 years, and that rents will be higher
so you'll be making much more cash flow each month. When you
look at the numbers, and the safety provided by investing in
something that everyone needs, it's hard to avoid the conclusion
that real estate is still a great investment as long as you buy
something that has positive cash flow from the start.
Investing in Crazy Times
These are interesting times. It's possible that real estate
prices will fall again, even though it has been making a comeback
in recent years. Meanwhile the stock market will crash again
at some point. Gold will reach its high for this run, and then
fall at some point (it seems that this may have already happened.
What can you do to invest wisely in this environment? If you
are young enough you can think very long term and buy good companies
in the stock market, but you should be prepared to see the prices
go down at some point.
Considering that you can make money on a house that drops
by half in value (see the example above), income-producing real
estate might be a good idea too. When you make money from the
start -- and every month -- it is harder to lose money in the
long run.
More than anything else, though, this is probably a great
time to invest in your own skills and education. That might mean
going back to school to get a degree that opens up better job
possibilities. It can also mean getting educated in the ways
of money, so you can manage what you have and stay out of trouble.
Learning how to do business is another great way to invest your
time and money. After all, if you learn how to make money you
could lose everything you have in an economic meltdown and still
make it all back in time.
Perhaps the best approach is a little bit of everything. Invest
in your financial education. Start a business. Buy some quality
companies in the stock market. Have some silver coins stashed
away for worst-case scenarios. Buy a rental house or other income-producing
real estate. Maybe even invest in some solid companies overseas
to grow your investments and protect yourself from dollar declines.
Get out of debt, except for debt that is necessary to buy a home
and some smart investments.
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