Psychological returns

Profits and tax avoidance can powerfully motivate your investment selections. However, like with other life decisions, you need to consider more than
the bottom line. Some people want to have fun with their investments. Of
course, they don’t want to lose money or sacrifice a lot of potential returns.
Fortunately, less expensive ways to have fun do exist!
Psychological rewards compel some investors to choose particular investment vehicles such as individual stocks, real estate, or a small business.
Why? Because compared with other investments, such as managed mutual
funds, they see these investments as more tangible and . . . well, more fun.
Be honest with yourself about why you choose the investments that you do.
Allowing your ego to get in the way can be dangerous. Do you want to invest
in individual stocks because you really believe that you can do better than
the best full-time professional money managers? Chances are high that you
won’t. Do you like investing in real estate more
because of the gratification you get from driving by and showing off your properties to others than because of their investment rewards? Such questions are
worth considering as you contemplate what investments you want to make.

Bond returns

When you buy a bond, you lend your money to the issuer of that bond (borrower), which is generally the federal government or a corporation, for a specific period of time. When you buy a bond, you expect to earn a higher yield
than you can with a money market or savings account. You’re taking more
risk, after all. Companies can and do go bankrupt, in which case you may lose
some or all of your investment.
Generally, you can expect to earn a higher yield when you buy bonds that
✓ Are issued for a longer term: The bond issuer is tying up your money at
a fixed rate for a longer period of time.
✓ Have lower credit quality: The bond issuer may not be able to repay
the principal.
Wharton School of Business professor Jeremy Siegel has tracked the performance of bonds and stocks back to 1802. Although you may say that what
happened in the 19th century has little relevance to the financial markets and
economy of today, the decades since the Great Depression, which most other
return data track, are a relatively small slice of time.

Savings and money market account returns

You need to keep your extra cash that awaits investment (or an emergency)
in a safe place, preferably one that doesn’t get hammered by the sea of
changes in the financial markets. By default and for convenience, many
people keep their extra cash in a bank savings account. Although the bank
offers the U.S. government’s backing via the Federal Deposit Insurance
Corporation (FDIC), it comes at a high price. Most banks pay a low interest
rate on their savings accounts.
Another place to keep your liquid savings is in a money market mutual fund.
These are the safest types of mutual funds around and, for all intents and
purposes, equal a bank savings account’s safety. The best money market
funds generally pay higher yields than most bank savings accounts. Unlike a
bank, money market mutual funds tell you how much they deduct for the service of managing your money. If you’re in a higher tax bracket, tax-free versions of money market funds exist as well. See Chapter 8 for more on money
market funds.
If you don’t need immediate access to your money, consider using Treasury
bills (T-bills) or bank certificates of deposit (CDs), which are usually issued
for terms such as 3, 6, or 12 months. Your money will surely earn more in one
of these vehicles than in a bank savings account. As rates vary by institution,
it is essential to shop around. The drawback to T-bills and bank certificates of
deposit is that you incur a penalty (with CDs) or a transaction fee (with T-bills)
if you withdraw your investment before the term expires

After-tax returns

Although you may be happy that your stock has given you an 11 percent
return on your invested dollars, remember that unless you held your investment in a tax-sheltered retirement account, you owe taxes on your return.
Specifically, the dividends and investment appreciation that you realize
upon selling are taxed, although often at relatively low rates. The tax rates
on so-called long-term capital gains and stock dividends are lower than the
tax rates on other income. In Chapter 3, I discuss the different tax rates that
affect your investments and explain how to make tax-wise investment decisions that fit with your overall personal financial situation and goals.
If you’ve invested in savings accounts, money market accounts, or bonds,
you owe Uncle Sam taxes on the interest.
Often, people make investing decisions without considering the tax consequences of their moves. This is a big mistake. What good is making money if
the federal and state governments take away a substantial portion of it?
If you’re in a moderate tax bracket, taxes on your investment probably run in the
neighborhood of 30 percent (federal and state). So if your investment returned 7
percent before taxes, you’re left with a return of 4.9 percent after taxes.

Analyzing Returns

When you make investments, you have the potential to make money in a variety of ways. Each type of investment has its own mix of associated risks that
you take when you part with your investment dollar and, likewise, offers a
different potential rate of return. In this section, I cover the returns you
can expect with each of the common investing avenues. But first, I walk
you through the different components of calculating the total return on an
investment.

The components of total return
To figure out exactly how much money you’ve made (or lost) on your investment, you need to calculate the total return. To come up with this figure, you
need to determine how much money you originally invested and then factor
in the other components, such as interest, dividends, and appreciation (or
depreciation).
If you’ve ever had money in a bank account that pays interest, you know that
the bank pays you a small amount of interest when you allow it to keep your
money. The bank then turns around and lends your money to some other
person or organization at a much higher rate of interest. The rate of interest
is also known as the yield. So if a bank tells you that its savings account pays
2 percent interest, the bank may also say that the account yields 2 percent.
Banks usually quote interest rates or yields on an annual basis. Interest that
you receive is one component of the return you receive on your investment.
If a bank pays monthly interest, the bank also likely quotes a compounded
effective annual yield. After the first month’s interest is credited to your
account, that interest starts earning interest as well. So the bank may say
that the account pays 2 percent, which compounds to an effective annual
yield of 2.04 percent.
When you lend your money directly to a company — which is what you do
when you invest in a bond that a corporation issues — you also receive interest. Bonds, as well as stocks (which are shares of ownership in a company),
fluctuate in value after they’re issued.

Inflation ragin’ outta control

You think 6, 8, or 10 percent annual inflation
rates are bad? How would you like to live in a
country that experienced that rate of inflation
in a day? As I discuss in Chapter 4, too much
money in circulation chasing after too few
goods causes high rates of inflation.

reichsmarks. People had to cart around so
much currency that at times they needed
wheelbarrows to haul it! Ultimately, this inflationary burden was too much for the German
society, creating a social climate that fueled the
rise of the Nazi party and Adolf Hitler.

A government that runs amok with the nation’s
currency and money supply usually causes
excessive rates of inflation — dubbed hyperinflation. Over the decades and centuries, hyperinflation has wreaked havoc in more than a few
countries.

During the 1990s, a number of countries, especially many that made up the former U.S.S.R.
and others such as Brazil and Lithuania, got
themselves into a hyperinflationary mess with
inflation rates of several hundred percent per
year. In the mid-1980s, Bolivia’s yearly inflation
rate exceeded 10,000 percent.

What happened in Germany in the late 1910s
and early 1920s demonstrates how bad hyperinflation can get. Consider that during this time
period, prices increased nearly one-billionfold!
What cost 1 reichsmark (the German currency in those days) at the beginning of this
mess eventually cost nearly 1,000,000,000

Governments often try to slap on price controls
to prevent runaway inflation (President Richard
Nixon did this in the United States in the 1970s),
but the underground economy, known as the
black market, usually prevails.

If you don’t continually invest in your education, you risk losing your competitive edge. Your skills and perspectives can become dated and obsolete.
Although that doesn’t mean you should work 80 hours a week and never
do anything fun, it does mean that part of your “work” time should involve
upgrading your skills.
The best organizations are those that recognize the need for continual knowledge and invest in their workforce through training and career development.
Just remember to look at your own career objectives, which may not be the
same as your company’s.

Purchasing-power risk

Increases in the cost of living (that is, inflation) can erode the value of your
retirement resources and what you can buy with that money — also known
as its purchasing power. When Teri retired at the age of 60, she was pleased
with her retirement income. She was receiving an $800-per-month pension
and $1,200 per month from money that she had invested in long-term bonds.
Her monthly expenditures amounted to about $1,500, so she was able to save
a little money for an occasional trip.
Fast-forward 15 years. Teri still receives $800 per month from her pension,
but now she gets only $900 per month of investment income, which comes
from some certificates of deposit. Teri bailed out of bonds after she lost sleep
over the sometimes roller-coaster-like price movements in the bond market.
Her monthly expenditures now amount to approximately $2,400, and she
uses some of her investment principal (original investment). She’s terrified of
outliving her money.
Teri has reason to worry. She has 100 percent of her money invested without
protection against increases in the cost of living. Although her income felt
comfortable in the beginning of her retirement, it doesn’t at age 75, and Teri
may easily live another 15 or more years.

The lowdown on liquidity

The term liquidity refers to how long and at
what cost it takes to convert an investment into
cash. The money in your wallet is considered
perfectly liquid — it’s already cash.
Suppose that you invested money in a handful
of stocks. Although you can’t easily sell these
stocks on a Saturday night, you can sell most
stocks quickly through a broker for a nominal
fee any day that the financial markets are open
(normal working days). You pay a higher percentage to sell your stocks if you use a highcost broker or if you have a small amount of
stock to sell.
Real estate is generally much less liquid than
stock. Preparing your property for sale takes
time, and if you want to get fair market value for
your property, finding a buyer may take weeks

or months. Selling costs (agent commissions,
fix-up expenses, and closing costs) can easily
approach 10 percent of the home’s value.
A privately run small business is among the
least liquid of the better growth investments
that you can make. Selling such a business typically takes longer than selling most real estate.
So that you’re not forced to sell one of your
investments that you intend to hold for longterm purposes, keep an emergency reserve of
three to six months’ worth of living expenses
in a money market account. Also consider
investing some money in highly rated bonds, which pay higher than money
market yields without the high risk or volatility
that comes with the stock market.

Weighing Risks and Returns

Just as individual stock prices can plummet, so can individual real estate
property prices. In California during the 1990s, for example, earthquakes
rocked the prices of properties built on landfills. These quakes highlighted
the dangers of building on poor soil. In the early 1980s, real estate values
in the communities of Times Beach, Missouri, and Love Canal, New York,
plunged because of carcinogenic toxic waste contamination. (Ultimately,
many property owners in these areas received compensation for their losses
from the federal government, as well as from some real estate agencies that
didn’t disclose these known contaminants.)
Here are some simple steps you can take to lower the risk of individual investments that can upset your goals:
✓ Do your homework. When you purchase real estate, a whole host of
inspections can save you from buying a money pit. With stocks, you can
examine some measures of value and the company’s financial condition
and business strategy to reduce your chances of buying into an overpriced company or one on the verge of major problems. Parts II, III, and IV
of this book give you more information on researching your investment.
✓ Diversify. Investors who seek growth invest in securities such as stocks.
Placing significant amounts of your capital in one or a handful of securities is risky, particularly if the stocks are in the same industry or closely
related industries. To reduce this risk, purchase stocks in a variety of
industries and companies within each industry. (See Part II for details.)
✓ Hire someone to invest for you. The best mutual funds (see Chapter 8)
offer low-cost, professional management and oversight as well as diversification. Stock mutual funds typically own 25 or more securities in a
variety of companies in different industries. The best exchange-traded
funds offer similar benefits at low cost. In Part III, I explain how you can
invest in real estate in a similar way (that is, by leaving the driving to
someone else).

Individual-investment risk

A downdraft can put an entire investment market on a roller-coaster ride, but
healthy markets also have their share of individual losers. For example, from
the early 1980s through the late 1990s, the U.S. stock market had one of the
greatest appreciating markets in history. You’d never know it, though, if you
held one of the great losers of that period.
Consider a company now called Navistar, which has undergone enormous
transformations in the past two decades. This company used to be called
International Harvester and manufactured farm equipment, trucks, and
construction and other industrial equipment. Today, Navistar makes
mostly trucks.
In late 1983, this company’s stock traded at more than $140 per share. It then
plunged more than 90 percent over the ensuing decade (as shown in Figure
2-3). Even with a rally in recent years, Navistar stock still trades at less than
$50 per share (after dipping below $10 per share). Lest you think that’s a big
drop, this company’s stock traded as high as $455 per share in the late 1970s!
If a worker retired from this company in the late 1970s with $200,000 invested
in the company stock, the retiree’s investment would be worth about $25,000
today! On the other hand, if the retiree had simply swapped his stock at
retirement for a diversified portfolio of stocks, which I explain how to build in
Part II, his $200,000 nest egg would’ve instead grown to more than $2,800,000!

Tracking your savings rate

In order to accomplish your financial goals (and some personal goals), you
need to save money, and you also need to know your savings rate. Your savings rate is the percentage of your past year’s income that you saved and
didn’t spend. Without even doing the calculations, you may already know
that your rate of savings is low, nonexistent, or negative and that you need to
save more.
Part of being a smart investor involves figuring out how much you need to
save to reach your goals. Not knowing what you want to do a decade or more
from now is perfectly normal — after all, your goals and needs evolve over the
years. But that doesn’t mean you should just throw your hands in the air and
not make an effort to see where you stand today and think about where you
want to be in the future.
An important benefit of knowing your savings rate is that you can better
assess how much risk you need to take to accomplish your goals. Seeing the
amount that you need to save to achieve your dreams may encourage you to
take more risk with your investments.
During your working years, if you consistently save about 10 percent of your
annual income, you’re probably saving enough to meet your goals (unless
you want to retire at a relatively young age). On average, most people need
about 75 percent of their pre-retirement income throughout retirement to
maintain their standards of living.
If you’re one of the many people who don’t save enough, you need to do
some homework. To save more, you need to reduce your spending, increase
your income, or both. For most people, reducing spending is the more feasible way to save.
To reduce your spending, first figure out where your money goes. You may
have some general idea, but you need to have facts. Get out your checkbook
register, examine your online bill-paying records, and review your credit card
bills and any other documentation that shows your spending history. Tally
up how much you spend on dining out, operating your car(s), paying your
taxes, and on everything else. After you have this information, you can begin
to prioritize and make the necessary trade-offs to reduce your spending and
increase your savings rate. Earning more income may help boost your savings
rate as well. Perhaps you can get a higher-paying job or increase the number
of hours that you work. But if you already work a lot, reining in your spending
is usually better for your emotional and economic well-being.

Diversify for a gentler ride

If you worry about the health of the U.S. economy, the government, and the
dollar, you can reduce your investment risk by investing overseas. Most
large U.S. companies do business overseas, so when you invest in larger U.S.
company stocks, you get some international investment exposure. You
can also invest in international company stocks, ideally via mutual funds.
Of course, investing overseas can’t totally protect you. You can’t do much
about a global economic catastrophe. If you worry about the risk of such a
calamity, you should probably also worry about a huge meteor crashing into
Earth. Maybe there’s a way to colonize outer space. . . .
Diversifying your investments can involve more than just your stock portfolio.
You can also hold some real estate investments to diversify your investment
portfolio. Many real estate markets actually appreciated in the early 2000s
while the U.S. stock market was in the doghouse. Conversely, when U.S. real
estate entered a multiyear slump in the mid-2000s, stocks performed well
during that period. In the late 2000s, stock prices fell sharply while real estate
prices in most areas declined, but then stocks came roaring back.

Counting Out Collectibles

The term collectibles is a catchall category for antiques, art, autographs,
baseball cards, clocks, coins, comic books, diamonds, dolls, gems, photographs, rare books, rugs, stamps, vintage wine, writing utensils, and a whole
host of other items.
Although connoisseurs of fine art, antiques, and vintage wine wouldn’t like
the comparison of their pastime with buying old playing cards or chamber
pots, the bottom line is that collectibles are all objects with little intrinsic
value. Wine is just a bunch of old mushed-up grapes. A painting is simply a
canvas and some paint that at retail would set you back a few bucks. Stamps
are small pieces of paper, usually less than an inch square. What about baseball cards? Heck, my childhood friends and I used to stick these between our
bike spokes!
I’m not trying to diminish contributions that artists and others make to the
world’s culture. And I know that some people place a high value on some
of these collectibles. But true investments that can make your money grow,
such as stocks, real estate, or a small business, are assets that can produce
income and profits. Collectibles have little intrinsic value and are thus fully
exposed to the whims and speculations of buyers and sellers. (Of course, as
history has shown and as I discuss elsewhere in this book, the prices of particular stocks, real estate, and businesses can be subject to the whims and
speculations of buyers and sellers, especially in the short-term. Over the
longer-term, however, market prices return to reality and sensible valuations.)
Here are some other major problems with collectibles:
✓ Markups are huge. The spread between the price that a dealer pays for
an object and the price he then sells the same object for is often around
100 percent. Sometimes the difference is even greater, particularly if a
dealer is the second or third middleman in the chain of purchase. So at
a minimum, your purchase must typically double in value just to get you
back to even. And a value may not double for 10 to 20 years or more!
✓ Lots of other costs add up. If the markups aren’t bad enough, some collectibles incur all sorts of other costs. If you buy more-expensive pieces,
for example, you may need to have them appraised. You may have to
pay storage and insurance costs as well. And unlike the markup, you pay
some of these fees year after year of ownership.
✓ You can get stuck with a pig in a poke. Sometimes you may overpay
even more for a collectible because you don’t realize some imperfection
or inferiority of an item. Worse, you may buy a forgery. Even reputable
dealers have been duped by forgeries.
✓ Your pride and joy can deteriorate over time. Damage from sunlight,
humidity, temperatures that are too high or too low, and a whole host of
vagaries can ruin the quality of your collectible. Insurance doesn’t cover
this type of damage or negligence on your part.
✓ The returns stink. Even if you ignore the substantial costs of buying,
holding, and selling, the average returns that investors earn from collectibles rarely keep ahead of inflation, and they’re generally inferior to
stock market, real estate, and small-business investing. Objective collectible return data are hard to come by. Never, ever trust “data” that
dealers or the many collectible trade publications provide.
The best returns that collectible investors reap come from the ability to identify, years in advance, items that will become popular. Do you think you can
do that? You may be the smartest person in the world, but you should know
that most dealers can’t tell what’s going to rocket to popularity in the coming
decades. Dealers make their profits the same way other retailers do — from
the spread or markup on the merchandise that they sell. The public and collectors have fickle, quirky tastes that no one can predict. Did you know that
Beanie Babies, Furbies, Pet Rocks, or Cabbage Patch Kids were going to be
such hits?
You can find out enough about a specific type of collectible to become a
better investor than the average person, but you’re going to have to be among
the best — perhaps among the top 10 percent of such collectors — to have a
shot at earning decent returns. To get to this level of expertise, you need to
invest hundreds if not thousands of hours reading, researching, and educating
yourself about your specific type of collectible.
Nothing is wrong with spending money on collectibles. Just don’t fool yourself into thinking that they’re investments. You can sink lots of your money
into these non-income-producing, poor-return “investments.” At their best
as investments, collectibles give the wealthy a way to buy quality stuff that
doesn’t depreciate.
If you buy collectibles, here are some tips to keep in mind:
✓ Collect for your love of the collectible, your desire to enjoy it, or your
interest in finding out about or mastering a subject. In other words,
don’t collect these items because you expect high investment returns,
because you probably won’t get them.
✓ Keep quality items that you and your family have purchased and hope
that someday they’re worth something. Keeping these quality items is
the simplest way to break into the collectible business. The complete
sets of baseball cards I gathered as a youngster are now (30-plus years
later) worth hundreds of dollars to, in one case, $1,000!
✓ Buy from the source and cut out the middlemen whenever possible. In
some cases, you may be able to buy directly from the artist. My brother,
for example, purchases pottery directly from artists.
✓ Check collectibles that are comparable to the one you have your eye
on, shop around, and don’t be afraid to negotiate. An effective way to
negotiate, after you decide what you like, is to make your offer to the
dealer or artist by phone. Because the seller isn’t standing right next to
you, you don’t feel pressure to decide immediately.
✓ Get a buyback guarantee. Ask the dealer (who thinks that the item is
such a great investment) for a written guarantee to buy back the item
from you, if you opt to sell, for at least the same price you paid or higher
within five years.
✓ Do your homework. Use a comprehensive resource, such as the books
by Ralph and Terry Kovel or their website at www.kovels.com, to
research, buy, sell, maintain, and improve your collectible.

Passing Up Precious Metals

Over the millennia, gold and silver have served as mediums of exchange or
currency because they have intrinsic value and can’t be debased the way
that paper currencies can (by printing more money). These precious metals
are used in jewelry and manufacturing.
As investments, gold and silver perform well during bouts of inflation. For
example, from 1972 to 1980, when inflation zoomed into the double-digit range
in the United States and stocks and bonds went into the tank, gold and silver
prices skyrocketed more than 500 percent. With precious metals pricing zooming upward again since 2000, some have feared the return of inflation.
Over the long term, precious metals are lousy investments. They don’t pay
any dividends, and their price increases may, at best, just keep up with, but
not ahead of, increases in the cost of living. Although investing in precious
metals is better than keeping cash in a piggy bank or stuffing it in a mattress,
the long-term investment returns aren’t nearly as good as bonds, stocks, and
real estate.
One way to earn better long-term returns is to invest in a mutual fund containing the stocks of gold and precious metals companies

Career risk

Your ability to earn money is most likely your single biggest asset, or at least
one of your biggest assets. Most people achieve what they do in the working
world through education and hard work. By education, I’m not simply talking
about what one learns in formal schooling. Education is a lifelong process.
I’ve learned far more about business from my own front-line experiences and
those of others than I’ve learned in educational settings. I also read a lot.

Consider your time horizon

Investors who worry that the stock market may take a dive and take their
money down with it need to consider the length of time that they plan to
invest. In a one-year period in the stock and bond markets, anything can
happen (as shown in Figure 2-1). History shows that you lose money about
once in every three years that you invest in the stock and bond markets.
However, stock market investors have made money (sometimes substantial
amounts) approximately two-thirds of the time over a one-year period. (Bond
investors made money about two-thirds of the time, too, although they made
a good deal less on average.)
Although the stock market is more volatile in the short term than the bond
market, stock market investors have earned far better long-term returns than
bond investors have. (See the “Stock returns” section later in this chapter
for more details.) Why? Because stock investors bear risks that bond investors don’t bear, and they can reasonably expect to be compensated for those
risks. Remember, however, that bonds generally outperform a boring old
bank account.
History has shown that the risk of a stock or bond market fall becomes less of
a concern the longer the period that you plan to invest. As Figure 2-2 shows,
as the holding period for owning stocks increases from 1 year to 3 years to
5 years to 10 years and then to 20 years, the likelihood of stocks increasing
in value increases. In fact, over any 20-year time span, the U.S. stock market,
as measured by the S&P 500 index of larger company stocks, has never lost
money, even after you subtract for the effects of inflation.

Get rich with gold and oil?

During the global economic expansion of the
mid-2000s, precious metals (such as gold), oil,
and other commodities increased significantly
in value. The surge in oil prices certainly garnered plenty of headlines when it surged past
$100 per barrel. So, too, did the price of gold as
it surged past $1,000 per ounce in 2008, setting
a new all-time high. These prices represented
tremendous increases over the past decade
with the price of oil having increased more than
600 percent (from less than $20 per barrel) and
gold more than tripling in value (from less than
$300 per ounce).
However, despite these seemingly major
moves, when considering the increases in the
cost of living, at $100-plus per barrel, oil prices
were just reaching the levels attained in late
1979! And even with gold hitting about $1,500
per ounce in 2011 as this book went to press, it
was still far from the inflation-adjusted levels it

reached nearly three decades earlier. To reach
those levels, gold would have to rise to more
than $2,000 an ounce!
So although the price increases in gold and
oil (as well as some other commodities) were
dramatic during the past decade, over the past
30 years, oil and gold increased in value less
than the overall low rate of U.S. inflation. So one
would hardly have gotten rich investing in oil
and gold over the long-term — rather it would
have been more like treading water.
I’d like to make one final and important point
here: Over the long-term, investing in a stock
mutual fund that focuses on companies
involved with precious metals (see Chapter 8)
has provided far superior returns compared
with investing in gold, silver, or other commodities directly.

The only real use that you may (if ever) have for these derivatives (so called
because their value is “derived” from the price of other securities) is to hedge.
Suppose you hold a lot of a stock that has greatly appreciated, and you don’t
want to sell now because of the tax bite. Perhaps you want to postpone selling
the stock until next year because you plan on not working, or you can then
benefit from a lower tax rate. You can buy what’s called a put option, which
increases in value when a stock’s price falls (because the put option grants its
seller the right to sell his stock to the purchaser of the put option at a preset
stock price). Thus, if the stock price does fall, the rising put option value offsets some of your losses on the stock you still hold. Using put options allows
you to postpone selling your stock without exposing yourself to the risk of a
falling stock price.

Steering Clear of Futures and Options

Suppose you think that IBM’s stock is a good investment. The direction that
the management team is taking impresses you, and you like the products
and services that the company offers. Profits seem to be on a positive trend;
everything’s looking up.
You can go out and buy the stock — suppose that it’s currently trading
at around $100 per share. If the price rises to $150 in the next six months,
you’ve made yourself a 50 percent profit ($150 – $100 = $50) on your original
$100 investment. (Of course, you have to pay some brokerage fees to buy and
then sell the stock.)
But instead of buying the stock outright, you can buy what are known as call
options on IBM. A call option gives you the right to buy shares of IBM under
specified terms from the person who sells you the call option. You may be
able to purchase a call option that allows you to exercise your right to buy
IBM stock at, say, $120 per share in the next six months. For this privilege,
you may pay $6 per share to the seller of that option (you will also pay trading commissions).
If IBM’s stock price skyrockets to, say, $150 in the next few months, the value
of your options that allow you to buy the stock at $120 will be worth a lot —
at least $30. You can then simply sell your options, which you bought for $6
in the example, at a huge profit — you’ve multiplied your money five-fold!
Although this talk of fat profits sounds much more exciting than simply buying
the stock directly and making far less money from a stock price increase, call
options have two big problems:
✓ You could easily lose your entire investment. If a company’s stock
price goes nowhere or rises only a little during the six-month period
when you hold the call option, the option expires as worthless, and you
lose all — that is, 100 percent — of your investment. In fact, in my example, if IBM’s stock trades at $120 or less at the time the option expires,
the option is worthless.
✓ A call option represents a short-term gamble on a company’s stock
price — not an investment in the company itself. In my example, IBM
could expand its business and profits greatly in the years and decades
ahead, but the value of the call option hinges on the ups and downs
of IBM’s stock price over a relatively short period of time (the next six
months). If the stock market happens to dip in the next six months,
IBM may get pulled down as well, despite the company’s improving
financial health.
Futures are similar to options in that both can be used as gambling instruments. Futures deal mainly with the value of commodities such as heating oil,
corn, wheat, gold, silver, and pork bellies. Futures have a delivery date that’s
in the not-too-distant future. (Do you really want bushels of wheat delivered
to your home? Or worse yet, pork bellies?) You can place a small down
payment — around 10 percent — toward the purchase of futures, thereby
greatly leveraging your “investment.” If prices fall, you need to put up more
money to keep from having your position sold.
My advice: Don’t gamble with futures and options.

Considering Cash Equivalents

Cash equivalents are any investments that you can quickly convert to cash
without cost to you. With most checking accounts, for example, you can
write a check or withdraw cash by visiting a teller — either the live or the
automated type.
Money market mutual funds are another type of cash equivalent. Investors,
both large and small, invest hundreds of billions of dollars in money market
mutual funds because the best money market funds produce higher yields
than bank savings accounts. The yield advantage of a money market fund
over a savings account almost always widens when interest rates increase
because banks move about as fast as molasses on a cold winter day to raise
savings account rates.
Why shouldn’t you take advantage of a higher yield? Many bank savers sacrifice this yield because they think that money market funds are risky — but
they’re not. Money market mutual funds generally invest in ultrasafe things
such as short-term bank certificates of deposit, U.S. government-issued
Treasury bills, and commercial paper (short-term bonds) that the most creditworthy corporations issue.
Another reason people keep too much money in traditional bank accounts
is that the local bank branch office makes the cash seem more accessible.
Money market mutual funds, however, offer many quick ways to get your
cash. You can write a check (most funds stipulate the check must be for at
least $250), or you can call the fund and request that it mail or electronically
transfer you money.
Move extra money that’s dozing away in your bank savings account into a
higher-yielding money market mutual fund! Even if you have just a few thousand dollars, the extra yield more than pays for the cost of this book. If you’re
in a high tax bracket, you can also use tax-free money market funds.

Generating Income from Lending Investments

Besides ownership investments (which I discuss in the earlier section
“Building Wealth with Ownership Investments”), the other major types of
investments include those in which you lend your money. Suppose that,
like most people, you keep some money in your local bank — most likely in
a checking account, but perhaps also in a savings account or certificate of
deposit (CD). No matter what type of bank account you place your money in,
you’re lending your money to the bank.
How long and under what conditions you lend money to your bank depends
on the specific bank and the account that you use. With a CD, you commit
to lend your money to the bank for a specific length of time — perhaps six
months or even a year. In return, the bank probably pays you a higher rate of
interest than if you put your money in a bank account offering you immediate
access to the money. (You may demand termination of the CD early; however,
you’ll be penalized.)

The double whammy of inflation and taxes

Bank accounts and bonds that pay a decent

return are reassuring to many investors. Earning

a small amount of interest sure beats losing

some or all of your money in a risky investment.

The problem is that money in a savings account,

for example, that pays 3 percent isn’t actually

yielding you 3 percent. It’s not that the bank is

lying — it’s just that your investment bucket

contains some not-so-obvious holes.

The first hole is taxes. When you earn interest,

you must pay taxes on it (unless you invest the

money in a retirement account, in which case

you generally pay the taxes later when you

withdraw the money). If you’re a moderateincome earner, you end up losing about a third

of your interest to taxes. Your 3 percent return

is now down to 2 percent.

But the second hole in your investment bucket

can be even bigger than taxes: inflation.

Although a few products become cheaper over

time (computers, for example), most goods

and services increase in price. Inflation in the

United States has been running about 3 percent per year. Inflation depresses the purchasing power of your investments’ returns. If you

subtract the 3 percent “cost” of inflation from

the remaining 2 percent after payment of taxes,

I’m sorry to say that you lost 1 percent on your

investment.

To recap: For every dollar you invested in the

bank a year ago, despite the fact that the bank

paid you your 3 pennies of interest, you’re left

with only 99 cents in real purchasing power for

every dollar you had a year ago. In other words,

thanks to the inflation and tax holes in your

investment bucket, you can buy less with your

money now than you could have a year ago,

even though you’ve invested your money for

a year.

As I discuss, you can also invest your money in

bonds, which are another type of lending investment. When you purchase

a bond that has been issued by the government or a company, you agree to

lend your money for a predetermined period of time and receive a particular

rate of interest. A bond may pay you 6 percent interest over the next five

years, for example.

An investor’s return from lending investments is typically limited to the

original investment plus interest payments. If you lend your money to Apple

through one of its bonds that matures in, say, ten years, and Apple triples

in size over the next decade, you won’t share in its growth. Apple’s stockholders and employees reap the rewards of the company’s success, but as a

bondholder, you don’t (you simply get interest and the face value of the bond

back at maturity).

Many people keep too much of their money in lending investments, thus allowing others to reap the rewards of economic growth. Although lending investments appear safer because you know in advance what return you’ll receive,

they aren’t that safe. The long-term risk of these seemingly safe money investments is that your money will grow too slowly to enable you to accomplish

your personal financial goals. In the worst cases, the company or other institution to which you’re lending money can go under and stiff you for your loan.

Running a small business

I know people who have hit investing home runs by owning or buying businesses. Unlike the part-time nature of investing in the stock market, most
people work full time at running their businesses, increasing their chances of
doing something big financially with them.
If you try to invest in individual stocks, by contrast, you’re likely to work at it
part time, competing against professionals who invest practically around the
clock. Even if you devote almost all your time to managing your stock portfolio, you’re still a passive bystander in a business run by someone else. When
you invest in your own small business, you’re the boss, for better or worse.
For example, a decade ago, Calvin set out to develop a corporate publishing
firm. Because he took the risk of starting his business and has been successful in slowly building it, today, in his 50s, he enjoys a net worth of more than
$10 million and can retire if he wants. Even more important to many business
owners — and the reason that financially successful entrepreneurs such as
Calvin don’t call it quits after they’ve amassed a lot of cash — are the nonfinancial rewards of investing, including the challenge and fulfillment of operating a successful business.

Similarly, Sandra has worked on her own as an interior designer for more

than two decades. She previously worked in fashion as a model, and then

she worked as a retail store manager. Her first taste of interior design was

redesigning rooms at a condominium project. “I knew when I did that first

building and turned it into something wonderful and profitable that I loved

doing this kind of work,” says Sandra. Today, Sandra’s firm specializes in the

restoration of landmark hotels, and her work has been written up in numerous magazines. “The money is not of primary importance to me . . . my work

is driven by a passion . . . but obviously it has to be profitable,” she says.

Sandra has also experienced the fun and enjoyment of designing hotels in

many parts of the United States and overseas.

Most small-business owners (myself included) know that the entrepreneurial

life isn’t a smooth walk through the rose garden — it has its share of thorns.

Emotionally and financially, entrepreneurship is sometimes a roller coaster.

In addition to the financial rewards, however, small-business owners can

enjoy seeing the impact of their work and knowing that it makes a difference.

Combined, Calvin and Sandra’s firms created dozens of new jobs.

Not everyone needs to be sparked by the desire to start her own company

to profit from small business. You can share in the economic rewards of the

entrepreneurial world through buying an existing business or investing in

someone else’s budding enterprise. 

Exploring Your Investment Choices

Who wants to invest like a millionaire?
Having a million dollars isn’t nearly as rare as it
used to be. In fact, according to the Spectrem
Group, a firm that conducts research on wealth,
8 million U.S. households now have at least $1
million in wealth (excluding the value of their
primary home). More than 1 million households
have $5 million or more in wealth.
Interestingly, households with wealth of at
least $1 million rarely let financial advisors
direct their investments. Only one of ten such

households allows advisors to call the shots
and make the moves, whereas 30 percent don’t
use any advisors at all. The remaining 60 percent consult an advisor on an as-needed basis
and then make their own moves.
As in past surveys, recent wealth surveys show
that affluent investors achieved and built on
their wealth with ownership investments, such
as their own small businesses, real estate, and
stocks.

Ultimately, to make your money grow much faster than inflation and taxes,
you must absolutely, positively do at least one thing — take some risk. Any
investment that has real growth potential also has shrinkage potential! You
may not want to take the risk or may not have the stomach for it.

Owning real estate

People of varying economic means build wealth by investing in real estate.
Owning and managing real estate is like running a small business. You need
to satisfy customers (tenants), manage your costs, keep an eye on the competition, and so on. Some methods of real estate investing require more time
than others, but many are proven ways to build wealth.
John, who works for a city government, and his wife, Linda, a computer analyst, have built several million dollars in investment real estate equity (the difference between the property’s market value and debts owed) over the past
three decades. “Our parents owned rental property, and we could see what
it could do for you by providing income and building wealth,” says John.
Investing in real estate also appealed to John and Linda because they didn’t
know anything about the stock market, so they wanted to stay away from it.
The idea of leverage — making money with borrowed money — on real estate
also appealed to them.
John and Linda bought their first property, a duplex, when their combined
income was just $20,000 per year. Every time they moved to a new home,
they kept the prior one and converted it to a rental. Now in their 50s, John
and Linda own seven pieces of investment real estate and are multimillionaires. “It’s like a second retirement, having thousands in monthly income
from the real estate,” says John.
John readily admits that rental real estate has its hassles. “We haven’t
enjoyed getting calls in the middle of the night, but now we have a property
manager who can help with this when we’re not available. It’s also sometimes
a pain finding new tenants,” he says.
Overall, John and Linda figure that they’ve been well rewarded for the time
they spent and the money they invested. The income from John and Linda’s
rental properties allows them to live in a nicer home.

Ultimately, to make your money grow much faster than inflation and taxes,you must absolutely, positively do at least one thing — take some risk. Any investment that has real growth potential also has shrinkage potential! You may not want to take the risk or may not have the stomach for it. In that case, don’t despair: I discuss lower-risk investments in this book as well.

Building Wealth with Ownership Investments

If you want your money to grow faster than the rate of inflation over the
long-term, and you don’t mind a bit of a roller-coaster ride from time to time
in your investments’ values, ownership investments are for you. Ownership
investments are those investments where you own a piece of some company or
other asset (such as stock, real estate, or a small business) that has the ability
to generate revenue and, potentially, profits.
If you want to build wealth, observing how the world’s richest have built
their wealth is enlightening. Not surprisingly, the champions of wealth
around the globe gained their fortunes largely through owning a piece (or all)
of a successful company that they (or others) built. Take the case of Steve
Jobs, co-founder and chief executive officer of Apple Inc. Apple makes computers, portable digital music players (such as the iPod and all its variations),
mobile communication devices (specifically, the iPhone), and software,
among other products.

Every time I, or millions of other people, buy an iPad, iPod, iPhone, and so on,
Apple makes more money (so long as they price their products properly and
manage their expenses). As an owner of more than 5 million shares of stock,
each of which is valued at about $300 per share, Jobs makes more money as
increasing sales and profits drive up the stock’s price, which was less than
$10 per share as recently as 2004.
In addition to owning their own businesses, many well-to-do people have
built their nest eggs by investing in real estate and the stock market. With
softening housing prices in many regions in the late 2000s, some folks newer
to the real estate world incorrectly believe that real estate is a loser, not a
long-term winner. Likewise, the stock market goes through down periods but
does well over the long-term. 

And of course, some people come into wealth the old-fashioned way — they
inherit it. Even if your parents are among the rare wealthy ones and you
expect them to pass on big bucks to you, you need to know how to invest
that money intelligently.
If you understand and are comfortable with the risks and take sensible steps
to diversify (you don’t put all your investment eggs in the same basket),
ownership investments are the key to building wealth. For most folks to
accomplish typical longer-term financial goals, such as retiring, the money
that they save and invest needs to grow at a healthy clip. If you dump all your
money in bank accounts that pay little if any interest, you’re likely to fall short
of your goals.
Not everyone needs to make his money grow, of course. Suppose that you
inherit a significant sum and/or maintain a restrained standard of living and
work your whole life simply because you enjoy doing so. In this situation,
you may not need to take the risks involved with a potentially faster-growth
investment. You may be more comfortable with safer investments, such as
paying off your mortgage faster than necessary.