Investing must be one of the most misunderstood concepts.
And no wonder… People talk about investing in their education, investing time in their relationship and even investing in a new winter coat.
The financial world only adds to the confusion; gold, art, stamps, classic cars and barrels of whisky are often seen as safe havens for your money.
And lately, investments have become even more obscure with the rise in popularity of Bitcoin and other cryptocurrencies.
Everything and anything is labelled an investment. Although some of these things may be valuable and trade for significant amounts of cash, they are not investments.
I don’t want to get pedantic about the definition of a word, but as a finance blogger, I feel it’s my duty to bring clarity to the world of investing.
So, it’s time to dust off the ol’ soapbox and step on for a lesson on the fundamentals of investing…
Income! Income! Income!
For an asset to be considered an investment, it must produce an income. This income is what investors receive in exchange for lending their money.
If there isn’t a cash return, then you’re effectively giving your money away.
That’s all you need to know to invest wisely.
I could finish this post here, but let’s drill this point home… Most people understand investing as putting their money to work for them.
Each pound you invest can be thought of as a little employee that goes to work for you.
Each pound works extremely hard and never takes a break – financial markets are open 24/7.
In exchange for hard labour, your pound is rewarded with a few pennies at the end of the year.
Now, bear with me, as this is where this analogy gets a little weird.
I want you to switch places with one of your pound employees for a second.
Imagine you were to bust your balls for an entire year without eating, sleeping or even taking a break for a shit… and then not get paid.
You’d be pretty pissed off, right? Well, that’s exactly what happens when you invest in anything that doesn’t produce an income.
Think about it… You work in exchange for a wage. Your money works in exchange for a return. If either you or your money goes to work and doesn’t get compensated for it, then what’s the bloody point?
That’s why “true” investors buy assets based on the likely income they’ll receive from holding the asset.
They value investments based on the safety of their capital and the security (and possible growth) of the income. Benjamin Graham, who taught Warren Buffet his style of value investing which helped him become the 4th richest man in the world, said it best:
“An investment operation is one in which after thorough analysis, promises safety of principal and a satisfactory return.”
There Are Only 3 Investments
There are only three investments that produce a reliable income: businesses, property and fixed income deposits.
There are no other investments.
Everything else is either a variation of these three investments (pensions, REITs, managed funds) or speculation (which we’ll get into later).
Let’s look at these assets individually to see why they qualify as a real investment.
Businesses provide value by offering a service or product for sale.
This exchange of value results in successful companies earning a profit, which can be retained for further expansion of the business or distributed to shareholders via a dividend.
You can invest in businesses by owning the entire company, or by buying shares.
Owning shares means you own a tiny slice of the company, which entitles you to share in its growth and profits (as well as its losses).
Bricks and mortar, in the many forms it takes (residential, commercial, industrial, listed property shares), is a sound investment because of rental income.
But be wary of bare land. It doesn’t produce an income and is therefore not an investment.
Buying land to develop is a business, and buying land in the hope that it will rise in value is speculation.
The grey area is properties that have low rents compared to the mortgage and other costs, and the investor ends up making a loss.
Properties with low yields are often viewed as good capital growth opportunities – and they also have the added benefit of tax write-offs for high earners.
But if you’re dependant on capital growth to make money, you’re speculating.
Fixed Income Deposits
The third type of investment is a “debt” investment.
Instead of owning assets, you loan your money to businesses to fund their expansion.
You’ll receive regular interest payments in exchange for “locking away” your money for periods ranging from 30 days to 10 years.
You can also loan your money to the government (gilts) or to councils to fund local projects.
Investing in term deposits, bonds or gilts is less risky than shares or property, and the income you’ll receive will be stable and consistent, but the overall return is lower.
Shares, property and interest-bearing loans all have intrinsic value because they generate income.
This income is incredibly valuable to investors because they can use it for further investment, to pay down borrowings or to live off.
If the income were to decrease or stop altogether, the value of the investment would plummet, and it may even become worthless.
Investing Vs Gambling
So, if an asset is only valuable if it earns money, why do “investors” sink their savings into things like gold, antiques and website domain names?
These other “investments” can retain their value, and they may even rise in value – sometimes at a rate that far exceeds the return you’d get from holding proper investments.
BUT, if an investment doesn’t produce an income, then the only way you can profit from it is by selling it for more than you paid for it.
You’re relying on the market to lift the value of your investment, or you’re hoping to offload your stake to another gullible investor for a higher price (the greater fool theory).
If you purchase gold – which is nothing more than a lump of metal from the ground – in the hope of making a profit, you aren’t investing, you’re speculating.
And another word for speculating is GAMBLING.
You’re betting on being able to pick the rise or fall of the market.
Time and time again, we’ve seen just how impossible it is to predict the direction of the market – even for financial analysts whose full-time job is to make such calls.
For every gambler that gets it right, there are millions more that get it wrong.
Even if you have some early success, you’re unlikely to make accurate calls consistently over time.
In the end, you’re going to have many more losers than winners.
But Speculation Has Its Place
Now for the curveball… I am not completely against speculating.
There is the potential to make bucket loads of cash from speculating, and possibly way more money than you could ever make from sound investing.
For example, early adopters of Bitcoin became millionaires overnight when mainstream media started reporting on it.
And London property investors, who can make a loss for several years with property in the capital being so expensive and the yields comparatively low, can then make fortunes in a just few short boom years.
They’re banking on capital growth to make money, but in the long-term, the rise in value of London property will likely supersede the return you’d get from holding positive cashflow property.
But despite the mind-blowing wealth creation opportunities, speculation should always come secondary to investing.
It should only be considered once you’ve built a diversified portfolio of real assets.
And like all gambling, you should only speculate with money that you can afford to lose.
Personally, I wouldn’t risk more than 5% of my net worth in speculative investments.
That’s where my risk tolerance lies. I would be devastated if I had half my money in cryptocurrency and I woke up to find that the market had crashed to zero.
If you’re thinking about taking a punt on the market, know how much you’re comfortable with losing.
There’s a very real possibility of losing it all.
The Final Word
Hopefully, this post has provided clarity on what it means to be an investor.
Once you realise that there are only three investments, the complex world of investing becomes much simpler.
At the very least, I hope it makes you think twice before gambling on gold, Bitcoin or the next speculative investment to attract the get rich quick crowd.
And if you still want to roll the dice, that’s your call. But make sure you know the difference between investment and speculation and gambling.
Investing is a marathon, not a sprint. If you stick to building a portfolio of quality assets that pay you, you can’t go wrong.