Building wealth requires investments into the business, mostly other people’s businesses. Contrary to many investment experts’ advice you don’t need to become an expert in asset allocation, portfolio balancing, or stock picking to build wealth.
The true meaning of investment
Investing money means you take your savings and buy something that appreciates and or is a business that makes a profit.
You can invest your money into art, gold or bitcoins, land, anything that seems to be rare, and hope to sell it at a higher price in the future. While many tout this as an alternative investment, it feels to me more like speculation.
You can also invest in a business you run. You can buy machinery, raw materials, pay labor and manufacture goods and sell them. Or you can invest in the advertisement for your goods and services and find more customers to sell to. All these are investments where you actively run a business.
The third kind of investment is to provide the capital for business and let others do the work. You can lend money to a business on fixed terms (buying bonds). You can also buy shares of the business (buying stock) for a proportionate share of the profits (dividends) of the business.
The point is that the value gets created by someone taking the capital and through some form of active labor and organizing turns it into more money, making a profit. The trick is to know how specifically you spend the money and how to organize the labor, as well as where the risks are to turn a profit.
Being an expert in business
If you know a specific area to invest in the right things and how to organize or work with these things to turn a profit, then you can run your own business.
For example in his youth, Warren Buffet bought pinball machines, placed them in barbershops (from “The Snowball”), and shared the revenue with the barber to make a profit. Of course, he had to empty the coin boxes regularly and had to make sure the machines were in working order. He was a teenager at the time and not an electrician or mechanic, but he had the savvy to run a business and put in the work to succeed.
Of course, not everyone has the talent to see the market for these services and run the business profitably. For those people there is the option to invest by providing the capital for other peoples’ businesses.
Being an expert in investment
If you feel like running a business is not for you, then you face the question “Who will be a trustworthy, successful business owner” to invest your money with? That question is not easy to answer if you are not a business expert yourself.
To solve this problem for the individual investor, there are banks and mutual funds, which act as middle-man.
If you invest your money into a Certificate of Deposit (CD) from a bank, they will invest it into loans they make to businesses and will guarantee you a certain rate of interest. However, most of the actual return on investment will land with the bank and only a small fraction will be the interest paid to you.
If you buy shares of a mutual fund then they invest the money into stocks and bonds traded on an exchange, a market for these kinds of investments. Essentially, you hire someone who buys and sells investments for you. This will expose you to a higher risk of loss of capital, than in the case of a bank, but also to a likely higher return on investment.
However, it turns out that mutual funds tend to also eat up more of the profit than is necessary. This is not really surprising if you realize that a mutual fund is a business as well and desires to turn a profit for the fund company, the money manager, and the bank holding the securities.
Hiring an expert in investment
The alternative to mutual funds is hiring an investment advisor. That advisor can suggest different types of investments, a so-called portfolio with the asset allocation that suits your goals.
More often than not, she advises buying different mutual funds, because they are convenient products for lower risk-taking.
However, now you have hired two sets of advisors, that want to have their share of the profits which the actual businesses do (hopefully) produce.
Following the wisdom of the crowd
Stock exchanges are efficient markets where to buy and sell stocks and bonds. Everyone involved tries to buy low and sell high, to make a profit. However, the underlying businesses take this capital and organize work so that goods and services are produced and profits are made. Overall they reflect the economy and are supposed to grow over time. To measure this growth of the market as a whole, an index is created.
An Index is a collection of many securities added up in a certain way, to measure the overall behavior of the market over time. There are many different indexes to reflect parts of the market. The simplest index includes a share of every stock offered on an exchange (total market index). Often an index is weighted by the size of the corporations included, measured in the share of the total market value.
A special kind of mutual fund is one that invests in the shares of a specific index (index funds). They have several advantages:
- diversification; investment in many securities lowers risk
- cost effective; you don’t need an (highly paid) expert to pick individual companies
- low turnover; less buying and selling leads to less taxes the investor can’t control
- does not under or over perform; by design, it always yields average market returns
Index funds are a smart investment choice
For an investor that is not an expert in business or investing, index funds are a good choice to invest their savings. They can expect to participate in the average market returns, no more no less.
I recommend index funds even for investors, that run their own business. The business owner already takes a concentrated risk in their own business. If she wants to invest their savings into securities, then the broad diversification of index funds is a good way to do it. Also, being an expert in her own business does not make her an expert in evaluating other businesses, only based on the public data and the news.
You may also be interested to read about which investments to make for maximum return