All investments involve risk, and it is the ability to minimize this risk while maximizing the returns that makes a great investor. The key concept outlined here is this: Maximizing your returns early on is minimizing your risk, and unfortunately, most people do not invest this way.
Most average investments are done as speculation, with risks poorly understood and much attention paid to the long term benefits of capital gains. Middle-class investors focus primarily in two areas: Mutual Funds, and their Home. What they are hoping for is appreciation; the likelihood that their assets (the funds, their home, or both) will be worth considerably more in the years to come than they originally paid for them. There are serious problems with this method of investment:
1. Hidden costs - Because the benefits of these investments are not realized until the point at which they are sold, inflation is a significant factor in devaluing the gains. Everyone knows that a dollar paid to them today is worth more than one they will receive a year from now, but we let ideas like compound interest impress us without ever considering that at the same time we’re being hit with compound inflation. Taxes are another large hidden cost; the government shows no signs of easing up on income taxes, and if we are planning for a successful financial life we need to anticipate that our tax bracket will rise, not fall. Last but not least there are maintenance costs to the upkeep of any investment, which means our investing dollars are not getting full value when they’re returned.
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2. The nature of speculation - No one can predict the future unerringly. What we’re hoping for when we make these types of investments is that they will be at a higher value during the precise time that we wish to sell. It’s been proven time and time again that this sort of prediction is incredibly difficult, and yet this is the most frequent type of investment thinking among people for whom investing is not their primary talent or occupation. Diversification is preached as a way to avoid losing the entire value of one’s portfolio; and yet our goal is not to avoid total losses, our goal is to achieve gains.
The problems listed above apply to all forms of investment in one degree or another, but some methods of investing are more insulated from them. Let’s take a smart, disciplined gambler (rare creatures that they are) as an example:
A gambler goes into a casino, and brings $1,000 to bet. If the $1,000 is lost, the gambler goes home. If the $1,000 is doubled, the original money goes into the gambler’s pocket, and from then on the gambler plays with house money (money won from the casino). Whatever happens with those winnings, the gambler has pulled out their original investment. In this way, the losses have been capped at a maximum of $1,000 . . . while the gains are unlimited if the gambler continues to win. It can be easily guessed, most gamblers do not play this way. Most investors don’t play this way either; quite the opposite, they tend to hold onto losing investments (sometimes losing much more than anticipated), and quickly selling off the winners.
Be disciplined like the smart gambler’s example above. One of the key questions an investor asks at the outset of an investment is "How quickly will I make my money back?" They are not concerned with the long term returns in the beginning, they just want their investment back so that they can play with house money. Then they can take their original investment and put it into something else, again pulling it out as quickly as possible. In this way their money multiplies and their investments become low-risk because their own money is no longer in them.
Stocks and stock-related assets can be used in this fashion if the dividends are pulled out. Many people continually reinvest their dividends or invest in companies that don’t pay them, rationalizing that this will make for a larger return in the future. While this is possible, every time they do this they are increasing their risks by lengthening the time that their money is still in the investment. Businesses and rental properties are also great ways to pull out continuous cashflow, leaving only as much money in as is needed to maintain the investment.
This strategy also prepares us well for retirement. Rather than hoping for some lottery-style win from our investments, we should realize the likelihood that we will need continuous monthly payments to support us when our salary is gone. Why not start those monthly payments now? In addition to lowering the risks mentioned above, this money can begin to replace employment income, making it easier for one parent to stay home with their children, or retire early, or simply allow for an improved lifestyle today. If your investment is a continuous part of your spending, there will be capital gains (or possibly a lottery-style win) in your future…just as there will be losses and investment failures, but either way you’ll be protected by taking your money out early, cutting your losses, and maximizing your wins.
