The three best ways to build long-term wealth are to invest in ownership investments: stocks, real estate, and small business. I’ve found this to be true from observing many clients and other investors and from my own personal experiences. The following sections outline these three ways in greater depth.
Socking your money away in stocks:
Stocks, which represent shares of ownership in a company, are the most common ownership investment vehicle. You’re an owner when you invest your money in an asset, such as a company or real estate, that has the ability to generate earnings or profits. Suppose that you own 100 shares of Verizon Communications, Inc., stock. With billions of shares of stock outstanding, Verizon is a mighty big company — your 100 shares represent a tiny piece of it.
What do you get for your small slice of Verizon? Although you don’t get free calling, you do as a stockholder share in the company’s profits in the form of dividends (quarterly payments to shareholders from the company) and an increase (you hope) in the stock price if the company grows and becomes more profitable. Of course, you receive these benefits if things are going well. If Verizon’s business declines, your stock may be worth less (or even worthless!).
As the economy grows and companies grow with it and earn greater profits, stock prices and dividend payouts on those stocks generally increase. Stock prices and dividends don’t move in lockstep with earnings, but over the years, the relationship is pretty close.
In fact, the price-earnings ratio — which measures the level of stock prices relative to (or divided by) company earnings — of U.S. stocks has averaged approximately 15 the past two centuries (although it tends to be higher during periods of low inflation). A price-earnings ratio of 15 simply means that shares of a company’s stock, on average, are selling at about 15 times the company’s earnings per share.
When companies go public, they issue shares of stock that people can purchase on the major stock exchanges, such as the New York Stock Exchange. Companies that issue stock are called publicly held companies. By contrast, some companies are privately held, which means that they’ve elected to sell their stock only to senior management and a small number of invited, affluent investors. Privately held companies’ stocks don’t trade on a stock exchange, thus limiting who can be a shareholder.
Not only can you invest in company stocks that trade on the U.S. stock exchanges, but you can also invest in stocks overseas. Many investing opportunities exist overseas. If you look at the total value of all stocks outstanding worldwide, the value of U.S. stocks is in the minority.
Tips:
A good reason for investing in international stocks is that when you confine your investing to U.S. securities, you miss a world of opportunities, like taking advantage of business growth in other countries, as well as diversifying your portfolio even further. (For more on diversification, see the later section “Spreading Your Investment Risks.”) International securities markets traditionally haven’t moved in tandem with U.S. markets.
Remember:
Investing in the stock market involves setbacks and difficult periods, but the overall journey should be worth the effort. Over the past two centuries, the U.S. stock market has produced an annual average rate of return of about 10 percent. However, as anyone who invested in stocks experienced firsthand in the late 2000s, stocks can drop sharply — worldwide, stocks were sliced approximately in half during the down market that ended in early 2009. So if you can withstand down markets here and there over the course of many years, the stock market is a proven place to invest for long-term growth.
You can invest in stocks (and bonds, which I discuss earlier in this chapter) by making your own selection of individual stocks or by letting a mutual (or exchange-traded) fund do the selecting for you.
Generating wealth with real estate:
Real estate is another financially rewarding and time-honored ownership investment. Real estate can produce profits when you rent it for more than the expense of owning the property, or you sell it at a price higher than what you paid for it. I know numerous successful real estate investors (myself included) who’ve earned excellent long-term profits.
Over the generations, real estate owners and investors have enjoyed rates of return comparable to those produced by the stock market. However, like stocks, real estate goes through good and bad performance periods. Most people who make money investing in real estate do so because they invest over many years and do their homework when they buy to ensure that they purchase good property at an attractive price.
The value of real estate depends not only on the particulars of the individual property but also on the health and performance of the local economy. When companies in the community are growing and more jobs are being produced at higher wages, real estate does well. When local employers are laying people off and excess housing is vacant because of overbuilding, rent and property values fall, as they did in the late 2000s.
Remember:
Buying your own home is a good place to start investing in real estate. The equity in your home (the difference between the home’s market value and the loan you owe on it) that builds over the years can become a significant part of your net worth. Over your adult life, owning a home should be less expensive than renting a comparable home.
REAL ESTATE’S ATTRIBUTES:
Real estate differs from most other investments in several respects. Here are real estate’s unique attributes:
- Usability: Real estate is the only investment you can use (living in or renting out) to produce income. You can’t live in a stock, bond, or mutual fund!
- Less buildable land: The demand for land and housing continues to grow with population growth. Scarcer land propels real estate prices higher over the long term.
- Zoning determinations: Local government regulates the zoning of property, and zoning determines what a property can be used for. In most communities, local zoning boards are against big growth. This position bodes well for future real estate values. Also know that in some cases, a particular property may not have been developed to its full potential. If you can figure out how to develop the property, you can reap large profits.
- Leverage with debt usage: Real estate is also different from other investments because you can borrow a lot of money to buy it — up to 80 percent or more of the property’s value. This borrowing is known as exercising leverage: With an investment of 20 percent down, you’re able to purchase and own a much larger investment. If the value of your real estate goes up, you make money on your investment and on all the money you borrowed.
- Diamonds in the rough: Real estate markets can be inefficient at times. Information isn’t always easy to come by, and you may encounter a highly motivated or uninformed seller. Do your homework and you may be able to purchase a property below its fair market value.
- Favorable tax treatment: The tax code preferentially provides additional tax deductions, exclusions, or deferrals of taxes on gains on many types of real estate that aren’t available on other types of investments.
Going the small-business investment route:
Many folks have also built substantial wealth through small business. You can participate in small business in a variety of ways. You can start your own business, buy and operate an existing business, or simply invest in promising small businesses.
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