Picture yourself at some point in the future doing whatever you like. Sailing yourself around the Mediterranean, shuttling from summer home to winter home, or even being able to move close to your grandkids in California. I am sure that you can picture every detail. Unfortunately, those scenes all have one thing in common: money. They all require that you have a significant amount of money saved up to enable you the freedom to do them. So how do you get there from here?
The key to successfully reaching all of these is that they are Long Term goals. That means that you have time to plan and prepare for them. The further away in time that they are, the more likely you will be to successfully get there. How you get there will be a matter of personal choice, but there are many options. Which ones you choose should depend on your personal risk tolerance level, how much money you have to invest, how much time you are willing to spend with your investments, and how much time you have to grow your money before you need to start using it.
It is unfortunate that so many people just equate investing with the stock and bond markets. It is true, that within them there are a huge variety of investments available that cater to all sorts of investors. Mutual funds call out to inexperienced and time-harried investors alike. Individual stocks provide all sorts of opportunities for those who can look deeper. Bonds provide security and a counter-balance to equity ownership. Hedge funds glitter with the promise of riches hidden behind a wall of risk. Even with all of those options, it still does not cover the full range of investment opportunities.
Hedge funds and commodities markets offer their own set of risks and rewards that can be large. Real estate supports a lot of people’s ambitions for long-term goals too. Even the lottery offers the potential for high rewards, although I cannot think of any professional advisor who would seriously suggest it.
Individuals to reach their own financial goals have used each of these options, and each of these options could be your ticket to reaching your financial goals. I am going to go through each of these options at a very high level. Most of these investment options have entire libraries written about how to invest in them, so I cannot address any single one in full detail in a short article like this.
Stocks, Bonds and Mutual Funds
These are the most commonly thought of method when somebody mentions investing. Who hasn’t thought of finding the next Walmart, Microsoft, or McDonalds? Invest a few thousand dollars and by the time you are ready to retire, you will have millions of dollars more than you ever dreamed. Yet for each Microsoft, there is an Enron that has drained people’s life savings.
Stocks are a way to become a part owner of a company. When the company does well, the stock will generally do well too. With the way companies operate, stockholders are the last people to be paid (after employees, creditors and the IRS). Despite that, stockholders still make billions of dollars each year through dividends and stock price growth. There are also years where they lose money as well. Yet, over the long term, the average stockholder has done very well.
Bonds are a less risky way to invest in a business, but there is also less rewards. Buying bonds means loaning money to the business in exchange for being paid back more money in the future. Since bondholders are paid before stockholders, there is less chance of losing money on the bond. It is also why bonds generally do not produce the same overall returns long term. Still, holding bonds is a good way to help even out the annual returns in your overall portfolio.
Mutual funds are a mix of stocks and bonds. Professional money managers pool together the funds from many investors and use their knowledge and the tools they have access to for determining which stocks and bonds to buy and sell. Since those professionals’ jobs are to understand those investments, in theory they should do better than non-professional investors should. In truth, they usually do better than investors who buy individual stocks and bonds, but not as well as the stock market indexes that are always reported on the news. They key with mutual funds is that they require a lot less knowledge and time to invest in than individual stocks and bonds and that they generally perform similarly to wider sections of the markets.
Hedge Funds
Hedge funds are another step removed from the individual businesses. They use financial instruments derived from stocks and bonds to help increase their returns. These derivatives use leverage to increase their returns, but that leverage also increases the risk. Often, hedge funds produce outstanding returns until the underlying security has significant problems. At that point, the hedge funds may go as far as shutting down completely due to huge losses. An example of this is what is happening in mid-2007 with mortgage-based hedge funds. Increasing defaults on sub-prime mortgages are reaching levels that are causing multi-billion dollar hedge funds to shut down.
Commodities
Commodities are simply goods that are produced in mass quantities and that have no differentiating qualities to separate out different manufacturers. Grains, meats and metals are examples of commodities. Commodities markets are ways to buy and sell these commodities. They are used by businesses that need those commodities, but the way they are structured also offers opportunities for investors to be involved and to make or lose large amounts of money as the prices of the commodities change.
Commodities use the concept of leverage extensively. In the most common form, investors buy an obligation to purchase a set amount of a commodity on a specific day at a specific price. An example would be for 1000 barrels of crude oil, 3 months from now, at $75 per barrel. Investors do not pay the $75000 up front. How much it costs will depend on the current price of oil, but say it costs $1500 (2%) up front. If the price of oil goes up, that contract will be worth more than I paid for it. At $80 per barrel, it would be worth about $5000 more yet it only cost $1500 up front. That is more than 300% what it cost originally.
The down side to leverage is that if the price went down, the contract could be worth a lot less, and the investor has to take the loss if he does not want to pay the $75000 and take delivery of the oil when the contract expires.
Real Estate
How many real estate gurus have we all seen touting their zero-down systems on late night television? How many of us have envied Donald Trump and his ability to make money repeatedly? How few of us have actually bought more real estate than the homes we live in and use (including vacation homes and time-shares)?
Real estate has many investment options as well. The simplest is to purchase some bare land and hold on to it. Years later, it will likely be worth more than it is now worth now. Other options include developing land into shopping centers, office buildings, and subdivisions. Another way of investing in real estate includes buying existing properties and renting them out for income. Other, more complex ways include short sales, tax liens, foreclosure, REO properties, flipping and brokering homes.
These options all require different amounts of time, hands on involvement and up front cash. Each can produce a significant amount of gains or losses depending on the specifics of each deal.
Asset Allocation and Diversity
Asset allocation is a popular topic for financial planners. It is simply a measure of how your invested capital is split up. It is a helpful tool to see how aggressive or conservative your portfolio is currently invested. For example, a stock and bond portfolio that is 90% stocks and 10% bonds would be considered an aggressive portfolio. 90% bonds and 10% stocks would be considered very conservative.
Diversity breaks up you asset allocation further. That 90% stocks would be divided into different categories for better analysis. For example, 20% may be considered large-cap growth stocks. This additional breakdown gives an idea of how volatile the portfolio will be. If you are heavily invested in a particular company or sector of the market, your returns will be more volatile than if your portfolio is divided more evenly across the entire market.
The concepts of asset allocation and diversity can be applied much further than just stocks and bonds. If real estate makes up most of your portfolio of investments, your overall returns will be very strongly influenced by the real estate market. If the local real estate market started doing poorly when you needed your money, your goals would be at risk. Diversity applies likewise. Sticking with real estate, if all you have are office buildings, a new developer who puts up many buildings can hurt your holdings significantly. If you are diversified within your real estate holdings, the impact will be less severe.
Summary
Each of these options has the potential to see you to your sought after long-term goals. What differs between them is how much money it takes to start investing, how much time it takes to see your return, and how much risk you have to take on to see a given amount of reward. In general, the sooner you get your money back, the higher the potential return, and the more leverage a transaction has the greater the risk of losing money instead of making it.
The best way to secure your future is to use a mix of investments. As one investment does poorly, another is likely to be doing better, and help keep your portfolio continually growing. Additionally, while you may be able to grow an initial investment into enough for your goals, you will be more likely to succeed if you continue to contribute additional savings to your investing over time.
Save money, invest wisely and widely, and I will see you in paradise.