Editor’s note: This article was first published in November 2012. The interest rates are those of Spain in late 2012: about 1.5% on interest-bearing accounts after the promotional period and 3-4% on 12-month fixed-term deposits. The funds “ending this year above 20%” refers to 2012, and the recent property boom refers to the Spanish housing bubble that burst in 2007-2008.
As we’ve said on several occasions, there are only 3 steps to financial freedom: 1. work, 2. saving and 3. investing. Apart from a few very rare and little-known exceptions, they always come in that order; there are no shortcuts. Still, even without shortcuts, the vehicle we choose determines how quickly we reach our goal.
After asking more than 10 people who, you could say, reached this goal a long time ago, I was surprised that… once you’ve heard one, it’s as if you’d heard them all, because their advice is practically the same. The truth is there is no other advice, although they differed in how much starting capital they needed. Let’s look at the returns and risks of the investment vehicles that anyone must use to reach financial freedom within a given time frame, but not before some initial advice that is even more important.
To start with, they all agree that if finance and investing don’t appeal to you, forget about anything other than working as an employee for the rest of your life, or at most you might manage to set up one of the small safe-haven businesses we’ve already talked about.
1. The first investment: time and knowledge
95% of the people who were misled by the banks over «participaciones preferentes» (preference shares that Spanish banks sold to ordinary savers) were wary of the stock market and had no financial background at all. That’s why they could be manipulated so easily, to the point of not knowing that the real name of this investment product contains the very word that puts them off: «preferred shares», with the difference that you can’t sell them whenever you like.
The first investment should be knowledge. You need to know everything about money, and even get familiar with most stock market terms, as well as the famous «inflation», because a fixed-term deposit at 2% can look profitable while, once inflation is factored in, you’ve actually lost money over time.
Knowledge of your risk profile and your risk tolerance. You already know that higher risk means higher returns, and more knowledge means more control over risk.
Instead of using the famous «if only I had» (if only I had more money, if only I had…), use what you have to get what you want. Set yourself goals within a reasonable time frame, and work out the return you need to reach that goal starting from your current savings and income. Do you need 5% a year, 10%, 20%, 50%? All of those returns are possible.
2. Balancing fear and greed
Fear and greed move the markets every day, but they can become our allies if we manage to balance them. The problem is that the fearful person does nothing out of fear, and the greedy one tends to slip up. Still, at least greed makes you try again and again, whereas the fearful person doesn’t even try the first time.
So yes, you have to be greedy, because you have to go all out, but remember the difference between ambition and avarice, greed’s two siblings. And fear, despite what some people think, is good to have, because it keeps you alert to the risks you’re taking and sometimes acts as a brake before we go off the road.
With that said, let’s move on to the investment vehicles usually used to achieve financial freedom and the returns these 10 people consider «fair» if things are done well.
1%, 2%, up to 4% or 5%: interest-bearing accounts, fixed-term deposits, sovereign debt
These experts all say that you should never have idle money (money that earns no interest), let alone pay someone to hold your money. However, while they favor interest-bearing accounts with no strings attached, they’re less keen on fixed-term deposits, except during the saving period.
Let me explain. In previous articles we’ve talked about the importance of building an emergency fund, money set aside for emergencies that should be able to support us for at least 6 months if we stopped earning income. Of course, an interest-bearing account would earn us 1.5% on average once the promotional period ends (see the best-paying interest-bearing accounts), which means inflation would eat up all the gains.
For a fixed-term deposit to pay off (3% or 4%), it has to be for at least 12 months, so it isn’t fully liquid: if you withdraw the money early, you’re penalized.
They all agree that when you start with little money, with only 1,000 to 5,000 euros saved, the return after 12 months isn’t very eye-catching. Once you understand investing, you realize how much money you missed out on during those 12 months, although you’d have had to take a risk you perhaps weren’t ready for back then.
Sovereign debt: with sovereign debt, as with corporate debt, it’s more or less the same story: for it to pay off you have to invest for the very long term, though at a given moment we can buy 6-month bonds.
8%: index funds, mutual funds, ETFs…
You know that personally I’m not a fan of mutual funds, although 60% of the people we consulted say they started with one of these products. Mind you, they knew exactly how the product worked and where the fund invested, so for them it was a good way to diversify their capital across different sectors, commodities, currencies and so on.
Even so, they warn that if you have no idea where the fund invests, you shouldn’t buy it, much less if it’s a «dressed-up» fund, such as guaranteed funds or similar. They say that when that kind of wording is used, it’s to catch the financially ignorant, who think they’ll make money because it’s «guaranteed».
That said, if you choose a good fund, they say 8% a year is perfectly normal, since right now there are funds that have made excellent use of the crisis and will end this year with returns above 20%.
15%: stocks
A while ago we talked about the reasonable average annual return for a stock market investor, which many experts put at 5%. The people we consulted say that if you do your homework properly, anyone who doesn’t get at least 10% a year shouldn’t be investing in the stock market. 70% say they achieved an average return of 15% a year, though without overdoing diversification across stocks, because diversifying is meant to reduce risk, but it’s sometimes confused with «not losing in exchange for not winning».
They advise picking stocks in an uptrend, or undervalued stocks waiting for new regulation in their sector or a change in the economic cycle. And if storms are heading for the ship you’re sailing in, you go ashore and lie in the sun. In other words, if markets are turbulent, there’s no need to have money invested. We simply get out and come back in when the storm has passed.
The other 30% say that during their first 5 years they made gains below 10%, and even had the odd losing year. They say that once they started learning about other investment products (they meant short positions), they began to make much more money, because they could take advantage of both market trends, up and down.
30%: real estate and stocks
20% of the people we consulted (that is, 2 of them) found the cure-all in real estate. They made a great deal of money in the 1990s and did it again during the recent property boom. They say that when there’s a property boom, you have to treat it exactly like a rising stock market driven by speculation.
You need to have a buyer before you buy what you’re going to sell them. Everything has to be very fast, and very aggressive in negotiation. What you must avoid is piling up stock (properties in this case), because in the stock market you cut your losses when the trend changes, but if the change of trend catches you in the property market, you have no choice but to get stuck with the properties. Along with stocks, this business is one of the most profitable if you know how to exploit it.
50%: your own business plus stocks
Without a doubt, the most profitable investment by far is in your own business, because even when we invest in the stock market, our gains depend on the companies’ decisions. In our own company, we make the decisions.
These people consider profitable businesses to be those that grow at least 20% a year during their first 3 years and give us an annual return of at least 30%.
They say many companies with a good business model fail to generate more income because they don’t know how to make their capital work. They estimate that a company without a good financial adviser loses, or rather forgoes, 15% a year that it could earn by moving its money intelligently in the short or medium term, as long as the company has the capital available, of course.
Having heard them all, I reaffirm something I’ve always said: there isn’t a single millionaire business owner who doesn’t invest, and there isn’t a single millionaire investor who doesn’t have their own business. So whether you like it or not, if your goal is financial freedom, you’re going to have to learn about finance.
