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.