Four Basic Ways to Grow Your Investments
How to Make Your Investments Grow
Unless you’re lucky enough to be born with a spendthrift trust fund, you will have to make your money the good old-fashioned way—by working for it.
But understanding how to make money can give you an advantage. Try these four basic ways to earn money, and these strategies could help you build a fortune.
Selling Your Time
This is the source of income that most people think of when it comes to earning money. This is the money you receive for selling your time to an employer, often represented as salary or wages. You’ll often hear well-intentioned parents telling their children to find a “good job," preferably one with benefits.
The rate you receive for your time depends on how rare and in-demand your skills are to society. A gifted brain surgeon, for instance, can charge millions of dollars per year because there simply aren’t a lot of people who can do the job.
Someone who pushes carts at a discount retailer earns less—not because they are any less intrinsically valuable as a person, but because many people have the ability to push carts, causing a huge supply of potential workers to drive down wages.
To earn more money, you have to invest in yourself and improve the rate you can charge, work more hours, or a combination of the two. This type of income is the most active form of earning a living because you only generate money when you are actually working.
A brilliant lawyer may earn millions of dollars a year, but they can’t continue to make money when they aren't working—until retirement, that is. Constantly working to continue making money may be fine if you love your job, but for many people, there may be other things they’d like to spend more time doing.
Earn Interest on Money Lent
This type of income comes from money borrowers pay you to “rent” your capital. The term "capital" refers to money you’ve set aside for investment purposes; you’ll hear it used a lot on Wall Street.
When you buy a certificate of deposit (CD) at a bank, for instance, you are lending money to the bank in exchange for a predetermined rate of return, which is typically a few percentage points per year. The bank takes the money it "rents" from you and lends it out at a higher rate, pocketing the difference.
This is why the yield curve is so important. It is the relationship between short-term and long-term rates. The steeper the yield curve, the more money your bank can make on that CD or savings account you have with them.
Here's an example of interest income: Michelle lends money to people who want to buy a house but have bad credit and are unable to get a mortgage through traditional channels. They buy a property, and she loans them the money to fund the purchase, charging 13% interest. For a typical $150,000 loan, Michelle will receive $19,500 per year in interest income, or $1,625 per month. In essence, her money is going out and working for her.
Dividend Income From Profits on Businesses Owned
This represents your share of the profits of a company in which you have bought an investment. If you own 50% of a lemonade stand, and the company had sales of $1,000 with costs of $500 and $500 in remaining profit, your share of those profits would be $250.
That money is paid out to you as your “cut” of the earnings. A good investment is one in which the company earns more year after year, increasing the amount of cash that is sent to you on a regular basis.
Just like interest income, the idea of dividend income is that your money is going out and working for you. There are some forms of labor, however, that can be included in this category. A salesperson who earns commissions on recurring orders with little or no work is essentially running a business. So, too, is the person who registers a new patent and earns royalties on it, or a songwriter who earns money when a recording star chooses their song for a new single. They are generating profits from the recurring “sale” of their idea or property.
Here's an example of dividend income: Tristan owns some rental properties. He buys real estate and then charges the tenants money to live in his houses. In these cases, Tristan's rental business is generating profit equal to the total rent he receives less any costs, such as maintenance and upgrades on the properties. At the end of the year when he takes the money out of the business, those profits represent dividend income.
Capital Gains Income
This type of income is generated when you buy an investment or asset for one price and sell it for another, higher price, making a profit. Going back to our example of a lemonade stand, if you bought your 50% stake in the business for $2,000 and sold it for $5,000, the $3,000 difference would represent your capital gain.
It doesn’t matter what we're talking about—houses, rare paintings, diamonds, fountain pens, businesses, furniture, Canadian Gold Maple Leaf coins, stocks, bonds, mutual funds, or unopened, mint-condition Barbie dolls—if you buy it at one price and sell it at another, the profit that results is known as a capital gain. If you lose money on the transaction, it’s known as a capital loss.
In recent years, many Americans found their standard of living artificially inflated during the housing boom. The capital gains resulting from their homes appreciating in value were sources of income they may have thought would continue indefinitely.
Let's take another look at our enterprising example from above. If Tristan were to sell one of the rental houses he bought for $80,000 to a buyer who was willing to pay $120,000, then the $40,000 difference represents his capital gain.
Benefits of Using All Four Types of Income in Your Portfolio
As your portfolio grows, you may find yourself earning all four types of investment income.
One income-generating method, the Berkshire Hathaway Model, states that the secret to true financial independence is working diligently to build a collection of “cash generators” that bring in huge amounts of the latter three types of investment income—interest, dividend, and capital gains.
Why is the focus on those three? There are a few main reasons. First, money made from selling your time—salary and wages—is often taxed at far higher rates than the other types of income. Second, there are only 24 hours in a day, so you can only work so many hours. At some point, it becomes physically impossible to sell more of your time.
With interest, dividend income, and capital gains, there are virtually no limits to how much you can earn. If each year, you put your money back into growing these sources, you may find yourself earning more than you ever imagined a few decades from now.