3 Questions To Answer Before You Buy Your First Investment
Get the Foundation Right Before You Construct Your Portfolio
A question I am asked fairly often by new investors is, "How can I build the best investment portfolio possible?" The problem with the inquiry, as well intentioned as it appears, is that there's no such thing as a "best" portfolio because every individual, and every family, has its own unique set of opportunities, risks, abilities, and emotional temperaments. What works for your neighbor or brother might not work for you.
In fact, what works for you in your 20's might not work when you're 70 and thinking about setting up trust funds for your grandchildren.
Here are three questions you should consider before you even start the process of constructing your investment portfolio.
1. In Which Asset Classes Will You Concentrate Your Funds and Why?
Every asset class behaves differently. That is the reason an asset allocation strategy is so important. Balancing the competing benefits and drawbacks of each of these asset classes, as well as taking into account the need you have for stable cash flow, will inform your decision about how to employ the money you are putting to work between them.
- Stocks have historically provided the highest long-term returns because they represent ownership stakes in real businesses that sell real products and services. Some of the profits are paid out as cash dividends and some go back into retained earnings on the balance sheet to fund future growth. Unfortunately, stocks fluctuate in day-to-day and even year-to-year market value, often significantly. It isn't unusual to watch the temporary quoted market value of your holdings decline by 30% or more at least once every 36 months. At least several times in your life, you will see your holdings decline by 50% on paper from peak-to-trough. It's the nature of the opportunity. For good companies, with real profits, this doesn't matter match.
- Real estate is the second best long-term holding. Although it tends not to grow much beyond inflation, unless you're fortunate enough to hold property in landlocked areas such as San Francisco or New York where supply is limited and population growth continues its upward trajectory, it does often keep pace with the inflation rate as well as throw off large amounts of cash that you can reinvest, save, or spend. For investors comfortable using a little bit of leverage in the form of secured mortgages, every dollar in equity can go much further as it will allow you to buy $2 or $3 worth of property. This can cause bankruptcy if things go south, but a wise and prudent real estate investor knows how to manage his or her risks.
- Bonds and fixed income securities represent a legal claim on the output of a company entitled to both a return of the money lent (principal) and "rent" on the money (interest) during the time the company used it. Bonds have an inherent safety mechanism in them that no matter how far the price declines, as long as the underlying company has the money to meet its contractual obligations, the bond will be redeemed at par on the maturity date. Unfortunately, when the inflation rate accelerates, the value of each future dollar you are promised decreases in terms of purchasing power. This can be devastating to long-term fixed-rate bonds that are locked in for 20 or 30 years.
- Cash and cash equivalents, including FDIC-insured bank deposits and short-term Treasury bills, are among the safest asset classes for an investment portfolio as they provide a lot of dry powder to pick up cheap stocks, bonds, and real estate during crashes or pay your bills during a second Great Depression, yet they return almost nothing. In fact, depending on the way you park the money, you might even be losing purchasing power after inflation. This wasn't always the case and surely won't be forever. The day will return will checking and savings accounts will generate good interest income for savers, but there is no telling if that is a year away or ten years in the future.
2. Will You Prioritize Cash Flow Over Long-Term Growth?
Even within asset classes, some investments plow their earnings back into future expansion while others distribute most of the income in the form of partnership distributions or cash dividends. One provides money that you can use today, the other can mean a much bigger reward later. Furthermore, even those companies that pay dividends can be a vehicle for long-term growth if you opt to plow the dividends back into more shares; over decades, the difference between reinvesting and not reinvesting the dividend income is enormous.
It's a very different investor who becomes an owner in a business like Kraft Foods, which is large, diversified, and slow-growing so it pays out most of its income and one who becomes an owner in Amazon, which has kept its cash to expand into e-reading devices, digital movies, digital music, groceries, light bulbs, and shoes.
The same goes for real estate investments. Some projects, especially those that utilize leverage or involve developing new projects, might require a lot of cash flow to be retained for the sake of building equity but can pay off bigger in the end, while others don't offer much opportunity for reinvestment, such as a profitable but landlocked apartment building that can't be expanded.
3. What Is Your Liquidity Need?
Liquidity is so important it even comes before earning a good return. What are your liquidity needs? What is the likelihood you will need to tap the wealth you've put aside? If you don't have at least a five-year horizon, most stocks and real estate (other than special operations or arbitrage) are out of the question.
Some investors follow general rules of thumb, such as always keeping at least 10% of their portfolio in cash equivalents for the sake of liquidity. Otherwise opt for less liquid assets at higher allocations, such as never keeping less than 25% of funds in high-quality bonds. The right answer depends on the price you can get at the time and the goal you have for your portfolio.