Climbing The Investment Ladder
In this website we write a lot about index fund investing as a way to build wealth. However, the truth is that there are many different pathways to building wealth. Just like there is not only one path to climbing a mountain, there are many different ways to win financially. So in this post we are going to delve into what I like to call climbing the investment ladder. Where we can learn about all the different investment categories out there so we can possibly add them to our portfolio in our climb towards wealth building.
Before we get started, let’s first talk briefly about why we want to first understand all different pathways to building wealth. Isn’t investing in stock market index funds enough? Yes. I love index funds. And I firmly believe that they are one of the best ways for individuals like you and I to build and grow our wealth. However, we have no idea what the future will bring. I mean who could have imagined COVID-19? Or Russia invading Ukraine? Therefore, risk mitigation is crucial to not only growing our wealth, but also protecting it.
Therefore, one of the best ways to achieve good risk mitigation is to build and cultivate our financial wealth with a more diverse set of foundations. A good analogy I like to envision is to think of all these investment categories as legs on a table. A three legged table can keep a table steady. But having four legs is better. More stable. And how about five? It can weather the toughest of storms. So as we go through these different investment categories, think of them as legs that you can add to your financial table to make it even more bullet proof.
1 - Your Career
Many of us might not initially see a 9-5 career as an investment. It is something we have to do in order to put food on the table and keep a roof over our head. But, if you look at the data, a 9 to 5 job is still the most common way that many people build wealth. In fact, the best chance that many Americans have of becoming a millionaire is through a professional degree. Think accounting, medicine, law or engineering.
According to “The Millionaire Next Door” by Dr. Thomas Stanley, 80% of millionaires have college degrees. And of them, a lot of them hold advanced degrees. Eighteen percent have master’s degrees, 8 percent have law degrees, 6 percent medical degrees, and 6 percent Phds
In general, many millionaires in America are fairly well educated and in addition have followed the traditional education and career paths. This seems contrary to what we see on the media about millionaires right? We think rebel college dropouts who started sensational companies.
But the reality is that those types of millionaires are exceptions rather than the norm. And to crack our skewed perception a little more, a typical millionaire doesn’t become one overnight. Most often, it takes a typical self-made millionaire decades to gain their wealth. This is why I believe the first investment category we want to master is a traditional career path. Building our career capital to grow our income and thus our wealth.
And this was true of me and my wife’s pathway to wealth. Our biggest asset to growing our wealth wasn’t investing in the stock market or real estate. It was our professional jobs from our professional degrees - in my case a MBA and for my wife her nursing degree. These degrees provided us the income and capital to climb the investment ladder.
And even if you want to let’s say start your own business eventually, being an employee first is actually the norm. According to a Harvard Business review, the average age of a successful startup founder is actually 45. And this is because a 45 year old has things that 22 year olds don’t have - number one experience and number two, money. Both that likely came from a traditional 9-5 career working for someone else.
So before we feel like we want to quickly climb up the ladder towards other investment categories, master this first. It will give you a solid foundation to enable you to be successful in the other categories. However, we don’t want to stop at this phase of the ladder.
When we rely only on our 9-5 job for our wealth and financial security, it is like trying to balance a table top on one leg stool. It can keep the table up, but it’s shaky. With one major event, it can easily topple over. So let’s add another leg to our table top to mitigate the risk of it falling over.
2 - Stocks
The second investment category to grow your wealth is stocks. And this is one that I talk about the most in this website because outside our careers, this is one of the most straightforward ways to additionally grow our wealth. But first let’s go over some basics.
Stocks simply represent an ownership interest in a corporation. When a company issues stock, it’s actually selling a small fractional share of its business to each person who purchases shares of the stock. And these stock shares can be exchanged, meaning bought and sold on the stock exchange where the company is listed.
The stock’s value at any given time depends on how much another buyer is willing to pay for a share of that company’s stock, and how much the seller is willing to accept. For example, if the outlook for the company is good, buyers might be willing to pay more than you paid for your share of stock, and if you sold it at the higher price, you’d make a profit. On the other hand, if you had to sell at a time when the price of the stock was lower than you paid, you’d lose money.
In general, it’s most often not a good idea to invest all of your money in just one company, since your entire portfolio’s investment performance would be tied to the fortunes of that particular company. If the company experienced problems, the value of your stock would most likely fall, and you could possibly even lose your entire investment, should the company go bankrupt. Ever heard of Blockbusters, Enron or Lehman Brothers?
However, while buying individual stocks is quite risky, the stock market as a whole in my perspective is one of the greatest investments accessible to regular individuals like you and I. And the best way to tap into this money making investment is to buy well diversified, low cost index funds. Here are a few specific funds that I like:
Vanguard Total Stock Market Index Fund, also known as VTSAX.
Vanguard S&P 500 Index Fund, also known as VFIAX.
Fidelity 500 Index Fund, also known as FXAIX.
They are also some of the biggest index funds in the world for a good reason. As you build your career and earn more money through your human capital, you want to start replacing your human capital with financial capital. Climb that investment ladder one rung up so your table is now more balanced with an additional leg to support it. Alright, but we don’t want to just stop at stocks because while they represent a great wealth building tool, at times they can be quite risky and therefore volatile.
3 - Bonds
The third investment category we want to add to our table of wealth is bonds. Now I want to clarify that bonds aren’t really a wealth growing tool. They are more like a wealth preservation tool. At a high level, a good way to think about bonds in comparison to stocks is to consider them as investments that will smooth out our volatile stock investment ride. Stocks are great wealth building tools for the long run, however in the short-term, they can be quite volatile. Moving up and down constantly at the whim of slightest threatening news.
Bonds, on the other hand, might not have the big long-term returns, but it doesn’t have all that volatility that comes with stocks. Let’s talk briefly about what bonds are fundamentally. Bonds are essentially loans made from investors to borrowers, to be paid back over a certain period of time. Many bonds require periodic payments, also known as coupons, to be paid to the investor over the term of the loan before the full principal balance is due at the end of the term.
The annual coupon payments divided by the price of the bond is what we call yield. For example, if you bought a bond for $10,000 and it paid you $1,000 a year, it would have a 10% yield. And bonds, as I mentioned earlier, are very important to our wealth building ride because most often during market-sell offs, bonds are one of the few asset categories that hold its value. Actually a lot of times it goes up in value.
This is because when investors sell their riskier assets, they turn to buy bonds. Commonly known as a “flight to safety.” What having bonds in your portfolio will do for you, is that durings times of market crash, where your stock investments can dip by 20-30%, your bond investments will hold your portfolio steady. Like a good anchor.
Now if you are in your 20s and 30s and don’t plan on dipping into your investments anytime soon, having the majority of your investments in stocks is a better move. You have time on your side to ride out the ups and downs of the stock market. However, if you are nearing retirement and want to tap into your nest egg soon, you want bonds in your portfolio. You don’t want to be caught in a situation where you need to pull your money from the stock market when it’s 20-30% down.
And in my opinion Vanguard Total Bond Market Index Fund, VBTLX is the one and only Bond Fund you need in your portfolio to help smooth out your investment ride. VBTLX is made up of over 10,000 individual bonds within its fund with varying credit ratings, issuers and maturity dates. And this wide diversification of VBTLX makes it one of the best choices when it comes to investing in bonds because it minimizes all the risks that come with holding individual bonds.
Alright, now with most individual investors like you and I, the three investment categories that we just discussed, our career, stocks and bonds are enough to provide us enough financial stability for the rest of our lives. However, as you build your wealth, you might feel like you want to add even more diversity to your portfolio. So let’s talk about the two more.
4 - Real Estate
The fourth investment category to grow your wealth is in real estate. And outside of stocks and bonds, real estate represents one of the most popular investment categories. Real estate is great because not only are you seeing cold hard cash income come when you rent it out to tenants, you can even use it yourself. My wife and I personally own rental property out of state and we often joke that if the worst comes to worst in California, we can always move into our less costly rental property.
Another major benefit to owning rental property besides the rental income is that if you manage your property correctly, you will have other people helping you to pay off the mortgage while you enjoy the long-term price appreciation on the property.Additionally, if you borrowed money when purchasing the property, your return can be magnified due to the leverage.
Let’s look at an example, let’s say you put down $50,000 for a $250,000 property. This means you borrowed $200,000 from the banks. Now a year later your property value appreciated by 20% to $300,000. If you were to sell this property now, you would have made $50,000 profit from your $50,000 down payment investment. Essentially a 100% return.
How long would it take to get a 100% return in the stock market? Definitely more than a year. Now if this sounds way too good to be true, don’t worry. It is. Debt, also known as leverage in this scenario is a double edged sword. It can help you gain a 100% return in this case, but it can also work against you if the value of the home drops. For example, let’s say the price of your home fell from $250,000 to $200,000 and you sold the house. Your initial down payment would be essentially gone because you still owe the bank $200,000.
Another thing to note regarding owning real estate is that it requires a lot of hands-on activity compared to other investments like index funds. If you are managing your own property, you need to deal with tenants, list the property for future tenants, provide ongoing maintenance and much more. However, if you are wise with your purchases. Meaning you aren’t taking unnecessary risks and you have enough cash to ride the ups and downs of the economy, real estate can be a positive benefit to your overall financial portfolio.
Another way to add real estate to your portfolio without the hassle of actually owning individual real estate properties is to purchase Real Estate Investment Trust, also known as REIT. A REIT is a company that owns, operates, and finances income-generating real estate. But what we really need to know is that they are modeled after mutual funds.
So buying a REIT is similar to buying index funds. Index funds allow us to buy publicly traded companies without buying individual stocks. Similarly, REITs allow us to tap into real estate investments without having to actually buy, manage, and finance any properties ourselves. Vanguard offers a solid REIT, the Vanguard Real Estate Index Fund also known as VGSLX. It has an expense ratio of 0.12%. It represents close to 170 (167) real estate companies that represent all different types of property investments in the real estate industry. Properties such as office buildings, hotels, and even residential homes. I wouldn’t make this a core holding in your investment portfolio, but it's good to consider it as an added diversity to your overall wealth.
5 - Small Business
The fifth investment category to grow your wealth is in a small business. This definitely isn’t for everyone, but as you have more options in your life, it could be something to consider. And this could look very different for everyone for there alot of pathways you can take. You could start your own business outright, create a side hustle, franchise or invest in someone else’s small business. The world is your oyster when it comes to options in this investment category.
And I say this could not be for everyone because owning and operating a business is not a small feat. A typical franchise operations manual, likely divided into multiple sub manuals, are 300 to 500 pages in length. That’s longer than my previous company’s accounting manual. Imagine trying to not only digest all the details of trying to run a franchise but actually managing a million dollar operation. Hiring, training, managing, etc. The list of activities never ends for a business owner.
However, with work comes reward and owning and operating a small business can generate much higher returns than many of the other investment categories we talked about in this post. If things go well, your return on investments are most often not in double digits, but triple digits. This is why owning and managing a small business can be tough, but also very rewarding.
