How to Get Rich from Your Investment Portfolio
Making Money from Your Investment Holdings Can Happen In One of 4 Ways
For a significant minority of investors, the objective of building an investment portfolio is not simply to attain financial independence but to get truly rich. It's not an easy task but it is one that millions of people have accomplished. (To help you determine what "rich" means to you, read How Much Money Does It Take To Be Rich?)
At the core of the process of getting rich from your investment portfolio is generating income; actually making money, putting that money to work in additional productive assets, then, like the instructions on a bottle of shampoo, "Wash. Rinse. Repeat." Given enough time, the power of compounding works its magic and soon your money is making more money than you could have ever imagined. In this article, we're going to take sort of a broad-based, academic view of the different mechanisms through which a portfolio generates surplus cash for the owners of the capital to enjoy.
#1: Earn Interest Income on Money You Lend
Some investors lend money directly. One of my grandmothers spent years building her savings nest egg and then, a decade or two ago, began directly underwriting mortgages to high-risk borrowers, securing the promissory notes by the underlying property, often at rates around 13% annually. She only operated within a small range of communities and towns with which she had been familiar for more than 70 years. In many cases, she would either sell the promissory notes to banks once payment history had been established or she would get refinanced out of the deal once the buyer was able to qualify for a traditional mortgage. In effect, she was "renting" her money to people who needed it to buy a home. She controlled her risk and kept a large enough portfolio of these properties that when one of them inevitably went into foreclosure, which happened from time to time, she faced no hardship until the process was completed.
Other investors prefer to invest in bonds issued by municipal governments, corporations, or other entities. These bond issuers then use the money raised to build factories, schools, hospitals, police stations, expand into new markets, launch advertising campaigns or whatever other purposes were mentioned in the bond offering prospectus. If all goes well, the bond owner receives interest income until the bond matures, at which point the entire principal is repaid and the bond ceases to exist.
#2: Collect Cash Dividends from Businesses You Own in Whole or Part
When you buy a business, whether you are talking about the corner drug store or a piece of a much larger conglomerate, such as a share of stock in Berkshire Hathaway, United Technologies, or General Electric, you have a chance to collect cash dividends. This money represents part of the profit that the company's Board of Directors decides to mail out to the owners based on their total stake in the business. The more equity (ownership) you have and the more profit a company produces, the higher your dividends are likely to be.
#3: Buy Shares, Reinvest Them, Sell Them at a Higher Price
When you buy an asset at one price and sell it at a higher price, the profit is called a capital gain. Business owners can often enjoy this outcome by taking profit generated from the company and reinvesting it into growth so future profits are higher. Imagine that you owned a hotel and continually plowed your earnings back into building additional hotels. Twenty-five years pass. If you've managed your capital allocation wisely, and the businesses themselves are high-quality, you're probably going to receive a much higher price than the sum of the aggregate profits you've reinvested when you go to sell your stake. This happens because the equity you are selling has more value; more buildings, more revenue, and more profit. It's akin to baking a cake; the eggs, flour, sugar, oil, and other ingredients come together to form something much more impressive than the sum of the parts.
It is important that you understand capital gains and cash dividends are not mutually exclusive. In fact, they almost always go hand-in-hand once a company is well-established and profitable. Some of the most successful companies in history made their shareholders rich because they both grew in value and provided a stream of earnings paid out to the stockholders. For example, a $10,000 investment in Wal-Mart at the time of its IPO in the 1970's is worth more than $10,000,000 between reinvested cash dividends and growth in the value of the business as stores rolled out across America.
These companies retained a lot of their earnings and funded growth. That growth allowed the dividend rate to be increased each year, as well. When you look at both of these things together -- capital gains and dividend income -- it is called total return.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.