There Are Only 3 Investments

Investing must be one of the most misunderstood ideas in personal finance. People talk about investing in their education, their relationships and even a new winter coat.

The financial world adds to the confusion. Gold, art, stamps, classic cars and casks of whisky are often sold as safe places for your money. Bitcoin and other cryptocurrencies have made things murkier still.

Almost anything gets called an investment. Some of these things are valuable and sell for a lot of money. In my view, they still aren’t investments.

I don’t want to be pedantic about a word, but as a finance blogger I want to bring some clarity. So let’s step onto the soapbox for a lesson on investing basics.

When investing, your capital is at risk.

Income, income, income

For an asset to count as an investment, it must produce an income. That income is what you get in return for putting your money to work, whether through dividends, rent or interest.

If there’s no cash return, you’re relying on someone else paying more for it later.

Think of each pound you invest as a small employee working for you. It works every day without a break. In return, it brings you a few pennies at the end of the year.

Now swap places with one of those pounds. Imagine working flat out for a whole year without eating, sleeping or a single break, and then not getting paid. You’d be furious, right? That’s what happens when you put money into something that produces no income.

You work in exchange for a wage. Your money works in exchange for a return. If either of you works and isn’t paid, what’s the point?

That’s why investors buy assets based on the income they expect to receive. They value an investment on the safety of their capital and the security, and possible growth, of its income.

Benjamin Graham, the father of value investing and Warren Buffett’s teacher, put it best in Security Analysis (1934):

“An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”

There are only 3 investments

In my view, only three types of asset produce a reliable income: businesses, property and lending.

Everything else is either a version of these three (pensions, REITs, funds) or speculation, which we’ll come to later.

Businesses

Businesses create value by selling a product or service. Successful companies make a profit, which they either reinvest to grow or pay out to shareholders as dividends.

You can invest in a business by owning all of it or by buying shares. A share makes you part-owner of the company, so you share in its growth and profits, and its losses.

Some companies pay no dividend and reinvest all their profit instead. They still produce income for their owners. You receive it through a rising share price, as long as the profits keep growing.

Property

Property in its many forms (residential, commercial, industrial or property shares) is an investment because it earns rent.

Be wary of bare land. It produces no income, so it isn’t an investment. Buying land to develop is a business. Buying land in the hope that it rises in value is speculation.

The grey area is property where the rent doesn’t cover the mortgage and other costs, so the owner makes a loss each year. Low-yield property is often bought for capital growth. But if you depend on prices rising to make money, you’re speculating.

Lending

The third type of investment is lending. Instead of owning an asset, you lend your money and receive interest in return.

You can lend to a bank through a savings account or fixed-term deposit, to companies through corporate bonds or to the UK government through gilts. Terms range from instant access to 30 years or more.

Lending is usually less risky than shares or property, and the income is steadier. The trade-off is a lower long-term return.

Shares, property and loans all have intrinsic value because they produce income. Investors can reinvest that income, use it to pay down debt or live off it. If the income falls or stops, the value of the investment falls too, and it can become worthless.

Investing vs gambling

If an asset is only valuable because it earns money, why do people put their savings into gold, antiques and website domains?

These assets can hold their value, and they can rise, sometimes far faster than real investments. But if an asset produces no income, the only way to profit is to sell it for more than you paid.

You’re relying on the market to lift its price, or on finding someone willing to pay more (the greater fool theory).

Buy gold, a lump of metal from the ground, hoping to make a profit, and you’re speculating. Another word for speculating is gambling. You’re betting on calling the market’s next move.

Time and again, we’ve seen how hard it is to predict markets, even for analysts paid full-time to do it. For every speculator who gets it right, many more get it wrong. Even if you have some early wins, you’re unlikely to keep making the right calls. Over time, losers tend to outnumber winners.

But speculation has its place

Now for the curveball: I’m not completely against speculation.

Speculation can make you a lot of money, sometimes far more than sound investing. Early Bitcoin buyers became millionaires as it went mainstream.

London property investors have often accepted low or negative cash flow for years because prices are high and rental yields low. They’re betting on capital growth, and in some boom periods that bet has paid off handsomely.

But however exciting the opportunities, speculation should always come second to investing. Only consider it once you’ve built a diversified portfolio of income-producing assets. And as with any gamble, only speculate with money you can afford to lose.

Personally, I wouldn’t put more than 5% of my net worth into speculation. That’s my risk tolerance. I’d be devastated if half my money was in crypto and I woke up to find it had crashed to zero.

If you’re thinking of taking a punt, decide how much you’re comfortable losing. There’s a real chance of losing all of it.

Crypto: Don’t invest unless you’re prepared to lose all the money you invest. This is a high-risk investment and you should not expect to be protected if something goes wrong. Take 2 mins to learn more.

Final word

I hope this post has made it clearer what it means to be an investor. Once you see that there are only three types of investment, the world of investing becomes much simpler.

At the very least, I hope it makes you think twice before betting on gold, Bitcoin or the next craze aimed at the get-rich-quick crowd. If you still want to roll the dice, that’s your call, as long as you know the difference between investing and speculating.

Investing is a marathon, not a sprint. Build a portfolio of quality assets that pay you, and time will do the rest.