Introduction
“An investment in knowledge pays the best interest” – Benjamin Franklin
In order to become wealthy, one must understand that earning money alone will not get you there. An individual must learn how to invest. When investing, an individual can make money through interest and dividend paying securities, cash flow from a business or real estate, or capital appreciation from assets such as securities or real estate. An individual must also understand too however that buying individual securities such as stocks or bonds can be very risky (depending on the risk class). What I mean is that not only can the individual security be risky, but the amount of capital used to purchase this security has an increased risk of being vulnerable to an incredible amount of variables, both within the general and specific market and within business operations of the security. I don’t think enough individuals understand the complexity of the financial markets and how incredibly unpredictable they really are. To counter this, an individual must instill diversification and think long term regarding their investing…at least up until you are ready.
Are You Ready?
What do I mean by ready? I mean an individual must be ready financially and mentally before venturing to purchase individual securities.
Financially
1. Emergency Fund: 6-9 months of savings should be established. I firmly believe the emergency fund should be tiered to possess a variety of diversified holdings (please see previous post regarding emergency fund).
2. Clear of Credit Card Debt: No credit card debt should be present. The interest rates on credit cards are too high to be ignored.
3. Positive Cash Flow: An individual must have and maintain a positive cash flow to ensure that a steady stream of income is coming in every month. You do not want to be in a position where the cash flow becomes negative and you are heavily invested into individual securities.
4. Automated Savings: an individual should have a certain amount (at least 20% in my opinion) of pay directed towards savings vehicles that possess broad and diversified index funds that are perfect for building wealth for the long haul.
How can one understand if they meet all of the mentioned criteria above? My strong recommendation is to install a free software tool called Personal Capital. It is an extremely powerful personal finance tool that connects and combines all of your financial assets and liabilities. As a result, you are able to view and track several components of your personal finances from one place. It is a game changer! Click here to download the software for free! Please also see my main page for an overview.
Mentally
1. The Knowledge: investing into individual securities, especially with a lot of capital, is pretty intense and complicated. Some of the brightest minds within the industry struggle in purchasing stocks that outperform the market. Therefore, it is crucial to acquire a firm understanding of the industry itself and the basics in purchasing securities. An investor must be aware of the risks involved. A famous example of not using diversification and investing large amounts of capital within one equity holding is the Enron Scandal. These poor investors (many of them employees encouraged to invest their entire portfolios into the company stock) did not realize that by investing large sums of their wealth into one holding would be absolutely devastating. Many investors would not recover and would become financially ruined. They lost everything.
2. The Swings: the market is full of volatility due to an overwhelmingly amount of variables. The swings refer to how abruptly the stock market can change directions and how strong the swing can be. If a heavy amount of capital is invested into a single security and the market swings down…a lot of novice investors will think that they need to get out of the market. This is actually the complete opposite of what an investor should do. You just bought high and sold low when you want to buy low and sell high. An investor needs to have the mindset to not panic when security values are low. Know the difference between cost and value as an investor.
3. Rolling the Dice: I think a tremendous amount of individuals are unaware of this. Due to the Efficient Market Hypothesis, which states that existing share prices incorporate and reflect all relevant information, an investor will have a hard time beating the market. Of course, it can be done. Various techniques including hedging and the use of options can be utilized for investors to beat the market. However, there is a ton of research indicating that an individual is just rolling the dice when a security is purchased. Just be aware of that.
4. The Grind: It is a true grind to purchase individual securities lucratively. A tremendous amount of patience, skill, and knowledge is required. You are always on the grind when you have individual securities in the market because you control how long you want the security in the market and how much capital to invest. This is different when approaching a long term investing strategy that could entail buying diversified low cost index funds because as long as you pay attention to your risk tolerance and time horizon…you are not really on the grind. You just keep buying into the market and you can enjoy the ride.
Diversification & Wealth
Diversification is a risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique illustrates that a well-constructed portfolio possessing various investments will yield higher returns and pose a lower risk than any individual investment found within the portfolio. For long term investing, this is the technique I swear by for many reasons. However, the main reason is that your long term investments should contain a large amount of capital. You do not want to mess around here. Holdings that have a time horizon that span decades should be invested broadly to be able to minimize risk and yield positive returns year in and year out.
Those who want to retire wealthy should have a great deal of capital invested. This capital should be allocated with diversification. If a large chunk of an individual’s net worth is tied up within individual securities, they are either nuts or uneducated. As an investor and future wealthy individual, you can’t afford to be either. Make sure that only “play” money is allocated towards purchasing individual securities. Play money is money left over after the above criteria within “Financially” are met. This should be a smaller amount at first. But as individuals age and acquire additional assets, more spending money can be tied up into individual securities.
Of course, you have Warren Buffett, one of the best investors of all time, saying “Diversification is protection against ignorance. It makes little sense if you know what you are doing.” Now…it is easy for this man to say this because he knows the ins and outs of the industry and markets. He is able to perform constant research to make extremely knowledgeable individual investment choices. From his point of view, studying one or two industries and using this knowledge to gain profit can be far more lucrative than utilizing a portfolio that stretches across several investment choices and industries. He may be right, however he’s Warren Buffett. For 99.99% of the remaining world’s population, we must rely on diversification in order to ride out the storm.
Closing
Several self-made millionaires recommend having a large amount of capital tied up into diversified earnings. At the same time, a small percentage of capital should be invested into risky earnings. BUT…make sure you are ready. Make sure you can afford it.
Redefine.
-James