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A Beginne'rs Guide To Investing

Investing"How many millionaires do you know who have become wealthy by investing in savings accounts? I rest my case." - Robert G. Allen

This is one of the reasons why it isn't enough to save our money in the bank. With the very low interest rates banks pay on deposits, it'll take a million years before we can become millionaires. Or at least save enough money for future needs.

Investing is the act of committing financial resources with the expectation of a significant amount of profit or return. Investing has for its goal the opportunity to earn a nice enough profit commensurate to risks taken.

The common types of investments are stocks debt papers, currencies, real estate and network marketing.


Stocks or shares of stocks, are financial instruments that represent  ownership of a company. The more stocks we buy, the more we own of the  company. Stocks can be bought and sold in an organized exchange or  market such as the New York Stock Exchange and Nasdaq or over-the-  counter, the latter meaning we'll have to personally look for counter parties to transact with. To buy and sell stocks in organized exchanges, you'll have to go through stockbrokers that are members of a particular exchange.

There are two ways to earn from investing in stocks: capital appreciation and dividends. Capital appreciation is when the price or market value of our stock investments exceeds our purchase cost. We make money when we sell our stock investments at a higher price.

Dividends are our share of the profits of the company. The company's board of directors may declare dividends to be paid to shareholders as of a certain date when the company performed well according to expectations. During times that it doesn't no dividends are declared.

Capital appreciation is the best way to earn significant returns on stock investments while dividends usually aren't that meaningful. Most people who hit the gold mine in stock market investing did so via capital appreciation of their investments.

Debt Papers

Debt papers are claims to money of other institutions, including the government. We primarily earn income on such investments through interest paid by the institutions that borrow our money.

Debt papers may be classified as either government securities or commercial papers. Government securities are debt papers issued by the government, which include treasury bills and treasury bonds. They can be Issued either in the local currency or in a foreign one, such as US dollars or the Euro.

We can also make money through capital appreciation. This happens when interest rates go down, which makes the market value of debt papers higher. When interest rates go up, the market values of such papers go down. Interest rate movements are of no value when we invest in debt papers With the intention of holding on to them until they mature and only matters if we need to sell the papers, i.e., convert them back into cash, before maturity.


We can make money by buying and selling different currencies. Just like capital appreciation in stocks we can earn money from changes in the currencies' prices or exchange rates.

Take for example the Japanese Yen (JPY). If the current exchange rate is JPY 120 per $US and we buy $1,000 worth of yen, we'll receive JPY 120,000. If the exchange rate changes to JPY 110 per $US, we can exchange our JPY for US$1,090.91, giving us a profit of $90.91.

Real Estate

We can invest in real estate in 2 ways: leasing it or selling it. Leasing is a more consistent source of cash inflows but it will take longer for us to recoup our capital. Buying and selling real estate - also known in the United States as flipping properties - can help us recoup our investments much faster but it can tie up our cash flows for a longer period because selling properties take time and unlike leasing, doesn't provide for regular cash inflows.

One downside to real estate investing is that it's very capital intensive, i.e., requires a great amount of money unlike investing in stocks debt papers and currencies. As such, the profits are also as handsome.

Network Marketing 

Also known as multi-level marketing or MLM network marketing is an investment that can provide multiple sources of cash inflows.

First is by selling the networking company s products, which we get at distributors' or wholesale prices, at retail prices. Second way is through commissions from recruiting people into the company. Lastly, we can earn from the sales and recruits of our recruits, also known as down-lines. Many
people get rich from the 3rd method because it's through it that they are effectively able to "multiply" themselves and their sales.

Active vs. Passive Investments

Active investments are those that require a great degree of active participation such as monitoring and management. Passive investments, on the other hand, require very little of such. Examples of active
investments include stock market trading, currency trading, the initial stages of network marketing and flipping properties. Passive investing includes a buy-and-hold approach in the stock market network marketing's latter stages and leasing properties.

Stock market trading is a short-term approach to investing wherein we immediately sell stocks as soon as we make a decent enough profit and buy again when prices dip significantly. Contrast this to what is known as a buy-and-hold approach, which is a passive form of investing. We simply buy stocks, forget about them and wait for them to increase in value over time. The potentially higher income that can be earned by actively trading has a trade-off: close monitoring and management. It's because if we miss a major market movement, we can lose money. A buy-and-hold approach on the other hand, doesn't require much monitoring. Bulk of the work comes before buying because we'll need to choose stocks that have very good long-term potentials of capital appreciation.

Currency trading is basically active investing as most currencies go up and down within a relatively fixed price range and all we have to do is time our purchases and sales as it moves within such ranges to make profits. As with stock trading, we need to regularly monitor and manage our investments here as a quick and significant market movement can spell the difference between large profits or losses.

In network marketing, the biggest chunk of the work comes at the start the first year or two - when we're just trying to build up our network and client base. Once we're able to do that, our clients start buying from us regardless if we sell to them or not and our network of recruits or down-lines are already consistently selling and recruiting, both of which can provide us a great source of passive income with little to no active involvement. Some of my friends who are successfully into this tell me that active management for them is simply checking their bank accounts for commissions that are credited and withdrawing them.

When it comes to real estate investing, we can also do it actively or passively. Leasing our properties is closer to passive investing because there's very minimal management and monitoring needed while rental income is generally constant. Active management can be limited to just checking on the properties every now and then, contract renewal or looking for new tenants, all of which can be outsourced to a reliable and trustworthy real estate broker as my father-in-law does. Flipping properties do require more work from choosing the property to buy, processing the transfer of ownership, fixing or modifying said property, actively marketing it and processing transfer of ownership to the buyer.

Risk and Return

There's one relationship that's central to successful investing: the higher is our expected return, the higher the risk we'll need to take. There's simply no getting around this relationship.

What is risk? It is simply the odds or the chances that something undesirable can happen. When it comes to investing, there are 3 kinds: market risk, credit risk and liquidity risk.

Market risk are the odds or chances that something undesirable particularly financial losses - can happen because of the movements in the market prices of our investments. Trading stocks and currencies and to some extent, buying-and-holding stocks, are the kinds of investments that
are most susceptible to this kind of risk.

When we buy a Stock or a currency, there's a chance that its price will go down instead of up. V%en that happens, we initially incur what is called a paper loss, which is simply a "theoretical" one. As long as we continue holding on to the Investment despite a drop in its price, we won't suffer the loss just yet. But when we sell at the lower price, the loss becomes real. 

There's a flip side to holding on to a market-driven investment when prices have already gone down. Sure, we may not realize the loss but we run the risk of suffering a bigger one down the line if the prices of such investments continue to go down even further. Know your markets well and exercise great care and wisdom when trading stocks and currencies.

Consistent with the risk-return relationship, stocks and currencies are two investments where we can earn the highest possible returns given the relatively higher market risk compared to, say, bank deposits, debt papers or real estate investments.

Credit risk is the chance or possibility that we won't be able to get our money back. This type of risk is primarily associated with investments in debt papers and to some extent, leasing of properties. With debt papers, there is a chance that the institution we placed or lent our money to may not be able to pay us back. In terms of property rentals, there's a risk that our tenants may not be able to pay the rent.

Government-issued debt papers, particularly those denominated in the local currency, are practically credit-risk free and thus have the lowest interest rates among debt papers. Governments have the sovereign power to print local money in the worst-case scenario that it becomes unable to pay local currency-denominated debts and so payment of such is practically assured. That's why in most countries, the interest rates on local currency denominated debt papers serve as the benchmark rates for commercial lendings and borrowings, where a certain amount of premium is added to compensate for the additional risk.

The last type of risk is liquidity risk, which is the possibility of not being able to liquidate or convert our investments back into cash on time when we need it. Investments with the highest liquidity risk are real estate investments because these are major investments that normally require a lot of money. Shares of stocks listed in major stock exchanges like the New York Stock Exchange and Nasdaq as well as major world currencies like the USD have the lowest liquidity risk because they can easily be bought and sold.

How much should I invest? 

To answer this question, we need to consider several factors: investment goals, current market rates of return, risk tolerance and time frame. The primary consideration of course is our goal, i.e., how much money do we need for the future. Once we establish that, we can work back the amount
we need to invest given our time frame and current market rates of return.

For example, we need $100,000.00 10 years from now. Further, if the expected average annual return for stocks currencies, debt papers, property rentals and flipping properties is 20%, 15%, 10% and 30%, respectively, we the estimated amount of investment needed today based on the time value of money would be:

Expected Average Annual Return
Amount To Invest Now (compounded annually)
Debt Papers
Property Rentals
Flipping Properties

It's not just a matter of choosing the investment that will require the least amount of money to achieve $100,000 in ten years. We'll also need to consider the amount of risk we're willing to take. Flipping properties may require the least amount of money in our example but we'll have to consider its high liquidity risk and the amount of active involvement needed to make it work. Investing in stocks may have the lowest liquidity risk and active management requirement but it also has the highest market risk. Debt papers may have the lowest market risk and possibly a middle-of-the-pack level of liquidity risk but as such, it also requires the highest amount of investment because of its low returns.

At the end of the day, we should choose an investment that best matches our risk tolerance and financial capacity.  

Inflation Benchmarking

When it comes to investing, it's not enough to look at the expected rates of return. We also need to consider the inflation rate, which is the rate at which prices in general increase. For purposes of investing, we need to look at inflation from another perspective the rate at which our money loses its purchasing power. 

How's that so? If at the same time last year, apples cost $0.50 per piece and today it costs $0.55, our $1.00 can no longer purchase 2 apples. The increase in the price of apples (inflation) meant that the same amount of money today can no longer buy the same amount of apples compared to last year. Using this analogy, we can say that an inflation rate of 3% means our money lost 3% of its purchasing power. 

Now what does this have to do with choosing investments? Everything. Remember that we invest our money to make it grow and allow us to meet future needs? Do you also remember that another reason we do it is because inflation causes the cost of our needs now to increase in the future? If we don't benchmark the expected returns of our potential investments against the prevailing and expected inflation rates, we may still end up losing money and fail to provide for our future needs. 

When choosing potential investments, the expected return should exceed inflation by at least the rate of return required to meet our future needs. 
Let me explain this better. 

Let's say that given the money that we have now, we need to invest at an average annual return of at least 10% for the next ten years to meet our projected financial need. If the average inflation rate for the last 10 years is 3%, we need an investment whose average expected annual return is at least 13%. Why? Because after we deduct inflation, we still have an expected average annual return of 10% (13% minus 3%). If the expected average annual return on an investment is less than inflation, we're 
actually going to lose money on it. 

This post first appeared on Credit Zeal, please read the originial post: here

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A Beginne'rs Guide To Investing


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