Step 3: INVEST THE DIFFERENCE, WISELY

What to do with your cash

You’ve earned, you’ve saved. You’ve got cash burning a hole through your pocket and you want to do something with it. You want your money to make you more money. But the question is, how?

This is probably the biggest topic of all, and many books have been and will continue to be filled with all the ways you can put your money to work. There’s a whole world of investment opportunities out there, and once you start to look, you will find people queuing up to take your money off your hands and promising you the world in return.

Let’s just lay out some basic principles of saving and investing to get you thinking along the right lines. Please don’t rush into anything you don’t fully understand or feel comfortable with. Much better to take your time to learn and be wise with your choices.

Saving cash is not investing. But you need to do it anyway.

If you were anything like me, you would have been brought up to think that putting money from your birthday into a tin (or ‘piggy bank’ as we called it), then later into a savings account was the sensible thing to do. You weren’t quite sure what for, but it’s what grown-ups did, so you’d better do it too. Then maybe when you were older, you’d find something big that you wanted to buy and you could use it for that.

My first piggy bank.

While the discipline I learnt as a young saver was good, the understanding of what else was going on was a bit lacking. Yes, on cash deposits in a bank or building society you get a bit of interest, but it’s not going to provide for your future.

Cash is useful because it’s there when you need it. It’s the ultimate ‘liquid’ asset. You can just spend it if you need to. You don’t have to sell anything or wonder if it’s value has gone up or down. It’s just cash. For that reason, having some around is very useful. We all need a certain amount in our accounts to just pay our bills monthly. I call this ‘working cash’. But there’s also the bigger pot that you need to have, for emergencies.

Cash is useful because it’s there when you need it. It’s the ultimate ‘liquid’ asset.

Stash some cash for emergencies

“Be Prepared.” The motto of the scouts all over the world. And it seems to be true that those who prepare for emergencies, seem to encounter fewer of them. Statistically, it doesn’t seem to make sense, but you will doubtless know someone in your life who just seems to be always having a hard time. Their car broke down, and the water heater or the A/C. And they needed to pay some medical bills at the same time. The list goes on.

The simple way to protect yourself against all of these things is to build yourself an insurance fund. A peace-of-mind pot of money that is there to prevent you from going into debt when an emergency arises.

Your personal insurance fund

This should be cash, in an easily accessible account, somewhere safe. You are only going to use it in case of an emergency, but when you need it, you want to be able to get at it quickly. Look for higher interest-paying savings accounts. You might get a higher rate on a fixed-term deposit account, where your money is kept in an account for a longer period of time, but just be careful that you can actually access it when you need it. You will likely lose some of your interest if you take it out before the end of the fixed term, but that’s a price you will have to pay. It might even keep you from dipping into it too often anyway, so maybe not a bad thing.

How much cash? Well, start off with a basic fund. $500-1000 (or your currency equivalent) depending on your income. If you’re young and single then the lower end might be fine. If you have a family, house, vehicles, etc then go for the $1000. This is to keep the wolf from the door.

(At this stage you also need to look at your debt situation and decide how to manage that. It’s a whole topic of its own, and not to be ignored. But for simplicity here I’ve assumed that you either don’t have any high interest rate debt and your payments on the rest are factored into your monthly spending.)

How big should my emergency fund be?

After you have the basic insurance fund, you want to try to build this up to between 3 and 6 months worth of expenses. Now, these are your basic expenses. Go back and have a look at your budget and ignore all the things that you could get rid of if you were suddenly unable to work. This is just what you would have to pay out if you were really stuck. Mortgage payments, groceries, transport, phone. Those kinds of things.

Should you go for 3 months or 6? Well, that depends on how secure your job is. As expats, we probably fall into the ‘less-secure’ category, and some professions even more so. If you lose your job, you may well have to move countries. In that case, definitely go for 6 months worth of expenses. Maybe more if you’re really worried. Have enough that you can sleep well at night. Then when you reach that figure, congratulate yourself, take a big breath and look at investing the rest.

(It’s worth mentioning briefly here that cash as an asset on its own is occasionally valuable. In a particular type of economic environment known as deflation, the value of cash actually rises over time as the price of goods fall. But that’s beyond the scope of this intro. Stick with the basics for now.)

WHAT TO INVEST IN

Investing at its simplest is having your money work for you, and earn a return. There are a few main things you can invest in, but they largely fall into 2 categories. You can buy:

  • Things that earn you an income
  • Things that are valuable

Things that earn you an income

The two main ‘assets’ or things that you can buy that earn you an income, are businesses or loans.

You were expecting me to say stocks or shares, and bonds weren’t you? Well, it’s the same thing. Let me explain.

Stocks and shares

By ‘buying businesses’, I really mean buying shares.

(You can go and buy actual businesses too, but that usually requires a lot more money. Real estate investing should fall into this category too, as it is effectivelybuying a business, but again, it genereally requires quite a lot of money to get started, so best left for a later date. )

Buying stocks or shares is simply buying a little tiny fraction of the ownership of a company. Imagine a giant company like Apple. Its shares are listed on the NASDAQ stock exchange, and there’s about 4.6 billion of them in existence at the last count. Now picture it as a giant cake. Cut that cake up into 4.6 billion pieces, and if you bought 1 piece of the cake, you would own 0.000000000217% of the cake.

That’s the same amount of the company Apple you would own if you bought 1 share. If you bought 5 shares (at the time of writing this, each share is worth $182), you would own a 1 billionth (0.000000001%) of the company. (Incidentally this would cost you about the same as the top of the range latest iPhone. But that’s not the point.)

By owning a little slice of the company, you get to enjoy some of the perks of ownership. You should be able to share in some of the profits of that company, and also the value of your ownership will change with the overall value of the company. This can go up or down, as a company’s fortunes change.

(In theory, by owning shares you may also have the right to vote at company meetings, but unless you own a really significant stake in a company, the directors aren’t likely to listen to you. Just one of the facts of life. Sorry.)

These shares in a company are bought and sold on the stock market, and the price is set by ‘the market’. Simply what people are willing to pay or want to get paid for their shares. 

What is the stock market anyway?

It’s a collection of market places or ‘exchanges’ (real places, but more commonly accessed now online) where shares in publicly listed companies and a few other types of securities, like bonds, are bought and sold. Simple as that. 

How do I earn money from owning shares?

Companies will typically pay out some of their profits to their owners (you, now that you own part of the company) several times a year. Maybe once, maybe twice or maybe more. These payouts are called dividends. And if you own some shares, those dividends will get paid into your account where you hold them as cash. We’ll come back to that point, but don’t dismiss it. Long term wealth is almost always made in stock market investing through using dividends. 

One term you might want to know is called yield. The yield of an asset is simply the payout divided by the price. If a share costs $100 and pays out $5 a year in dividends, its yield is 5/100 = 5%. Knowing the yield of various assets allows you to compare them, based on how much they pay out.

The price of a share also varies according to what people are willing to pay for it. Many things can influence this, but basically, the price of shares depends on the future prospects of a company’s profits and the likelihood of you seeing them paid out.

So you can earn money from dividends and from the price of a share increasing over time, and then you selling it at a higher price later on.

Funds

Shares can be bought individually, or as part of a fund. If a share is like owning a small slice of a company (picture a little slice of a big cake), a fund is like a big box of cakes. Lots of slices of different cakes made by different people and with different recipes. It is a big basket of shares that come from lots of different companies. And you can own part of that basket by buying shares or units of the fund.

A fund will typically own shares in tens or even hundreds of companies, and by just buying one share in the fund, you indirectly now own little pieces of the profits, gains, and losses from all of those companies that the fund is invested in. Spreading out your investments like this is the definition of ‘not having all your eggs in one basket’. It reduces risk, simplifies things, and definitely reduces the costs of ownership for you.

Spreading out your investments like this is the definition of ‘not having all your eggs in one basket’.

A fund is set up with a particular aim. That is usually to invest in companies that all have something in common. Like they’re all listed on the London Stock Exchange, or they’re all really big. Or they all mine for gold. Something like that. Instead of you receiving hundred of tiny dividends from the individual companies, they get paid out to the fund, which then pays them to you once, twice or four times a year.

(There are also things called investment trusts. These are actually companies that are set up and work similarly to funds but with a few important differences, but I won’t go into detail right here. We’ll save that for another article.) 

Bonds

Bonds are simply loans. A bond fund, is a collection of loans.

These loans are either to a government or to companies. These organisations borrow money by issuing bonds, on which they then pay interest for a fixed period of time. A lot like an interest-only mortgage.

You can own these loans and receive that interest. You just have to buy bonds.

The interest paid on a bond is called its ‘coupon‘, and the time that the bond has left to run on that bond is called the duration. A bond fund will have a coupon that it pays out to you, the owner, which is the sum of all the coupons it receives (minus any costs). It also has an average duration, which is the average length of time the bonds contained in it still have to run.

Bonds typically vary in price less than shares, as you know exactly what you’re getting back from a bond. Unlike shares, with bonds, the payout is fixed. There is always the chance that a bond could be ‘defaulted on’, or not paid out. This might happen if the company goes bust. But as long as whoever issues the bond remains solvent, you will get paid out the coupon for the duration of the bond, then get paid back your original loan amount at the end.

In practice this rarely happens since people typically buy a bond fund, and the fund managers will do the actual buying and selling of the bonds in the background. You never have to deal with them expiring or buying new ones. You just choose a fund that suits your criteria, and let it do the work.

So these two assets cover the majority of what people invest in. Other types of businesses you could invest in might be real estate or even a physical business. Both are valid asset classes, but they’re a lot more involved to get into, so lets just start with bonds and shares for now. They’re easier to understand and much easier to get started with.

BUYING OTHER VALUABLE THINGS

The other type of asset that you could invest in is things that area valuable. Everything thing has some value, of course; the chair you’re sitting on or the food in your fridge both have a value. But they’re hard to sell or to realise that value from.

In the investing world, people buy assets that are in high demand, and that are easy to sell on to someone else who might want them in the future, hopefully for more than you paid for them.

Gold is the classic one here. Silver too. There’s plenty of other precious metals that fall into this category, but those two have historically been used as money for centuries. J.P. Morgan of investment bank fame once said that gold was money, and all other currencies were just credit.

“Money is gold, and nothing else.”

J.P. Morgan

There’s a lot of truth in this, but precious metals have some downsides too.

Other things like corn, wheat, timber, and oil are all valuable and are generally known as commodities. They’re not as valuable as precious metals, and their price can fluctuate a lot. But they are bought and sold and some people view them as an investment.

To give buying-valuable-things its proper name, it should really be called ‘speculation’. You are betting on the price of something rising to give you a profit. With shares and bonds, even if their price never changes, you can still earn a profit from the money they pay out as dividends and coupons. But there are good reasons to use buying-valuable-things as part of your investing toolkit.

Why you should probably own some valuable stuff

Firstly, many people would argue that it’s not worth investing in valuable things. They are just ‘stuff’ and don’t pay you any money, so it’s pointless owning them. They have a point, but I believe they’re wrong. Here’s why.

In certain types of economic environments, the price of things tends to go up. Have you noticed that? Remember the price of your favourite snack from when you were young? A fraction of what it is today. How about your parents’ first house? It sounds fantastically low by todays prices doesn’t it? Well price increases over time are known as ‘inflation‘.

How to benefit from inflation

Sometimes inflation gets out of hand. Look at Venezuela or Zimbabwe for example. You think that doesn’t happen in your home country? Ask anyone who remembers the 1970s, or 1990 well. In the UK, interest rates got up to, or even above 15% per year. When inflation takes off, interest rates shoot up as central banks try and bring it under control. In these types of environements, when inflation is high, the price of valuable assets such as gold, go up. They are protection against inflation.

This also happens when people are scared. When big scary events happen around the world and the prospects for businesses don’t look good, people view gold, and also silver, as a safe store of wealth. As the demand for them increases, so does the price. The price of silver tends to be more volatile than gold and it amplifies its moves. The gold price can be volatile. The silver price, very volatile.

In short, gold is a useful bit of insurance against bad things happening and also against high inflation. It doesn’t pay you anything, but it can be a store of wealth when everything else is falling in value. For those reasons, it’s probably wise to own some. If you don’t, you may only come to regret it when it’s too late.

INVESTMENTS IN SUMMARY

A list of the different asset classes most useful to a beginner investor are:

  • Shares
  • Bonds
  • Cash
  • Gold
  • (Other things that pay you money, like real estate and physical businesses)

The only free lunch in investing

Diversification.

By diversifying your investments across different assets classes it is possible to reduce risk, volatility and actually improve the return on your whole investment portfolio.

Don’t keep all your eggs in one basket.

Which ones should you own? Own a bit of all of them. Different assets do well at different times, and no-one really knows which ones will do well in the future. The best and wisest way to invest is to spread your investments across different classes. Don’t keep all your eggs in one basket. How you decide to divide your money up is knows as ‘asset allocation’ and is a lesson of its own.

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