Now that we understand what investing is and why it is so powerful, the question becomes, “Where can I put my money to earn a high rate of return?”
The answer is to buy assets.
An asset is something that has monetary value. Entrepreneurs create assets and investors purchase them. There are different aspects of an asset that make it have that value. Understanding the different types of assets in terms of how they generate value is fundamental to becoming an investor, because you’ll understand how returns are generated. Let’s look at the four types of assets from the perspective of how they generate returns.
This is the most comment type of asset there is, and examples are all around us. The device you’re reading this on is one example. Maybe its an iPhone, a tablet, or a laptop. At some point, you purchased it or it was purchased for you by someone else as a gift.
Consumption items (also known as depreciating assets) are assets that gradually have less value over time. This is usually because they become inherently less useful, or are less attractive relative to new versions of the item.
Cars are a great example of this. The average new car in America costs somewhere around $30,000 [cite source]. Within the first five years of a car’s life, it goes down in value an average of 40% [cite source]. This is why used cars tend to be much more affordable than new ones, particularly when economic times are good and most people who purchase a car would rather opt for a new one.
Although cars have real utility – they provide transportation – their value inevitably declines as newer, prettier, and more efficient models are developed and marketed by auto manufacturers. The same is true for almost any consumption item, such as a smartphone, television, or sofa in your living room.
Unless you have the skills to bring an old item back to life – such as refurbishing old furniture or repairing a broken laptop – these are not great assets to invest in. They are things to consume and enjoy for the purposes of living our lives, but don’t serve any financial purpose except to maybe sell it at a lower price and use the money for something else.
Depreciating assets that produce income have some value to us as investors, though it is limited and primarily based on the cash that it can provide. Take something like a patent for an invention. It may produce royalties based on its usefulness, but over time it becomes worth less and less if something else is invented that makes it obsolete.
Another example is music royalty rights. When a song is popular, it generates a steady stream of cash. However, if the artist’s work fades from the limelight and they don’t continue to produce hits, over time the music becomes less valuable from a financial perspective.
Sophisticated investors may choose to invest in this arena (with industry-specific expertise), but these types of assets are not something that beginners should consider for investment.
As investors, we want to own things that grow! If something grows in value over time, it falls into this category. A perfect example is when someone buys a personal residence. It has a certain value when it is purchased, and then over time the value grows.
This isn’t just true of real estate, but of many different types of assets, which we’ll learn more about in Part IV. Stocks are growth assets. Artwork, collectibles, and precious metals can be growth assets. If it increases in value over time, particularly if it does so at a rate much higher than inflation, then it may be fertile ground for us as investors.
Growth assets that produce income can be attractive to investors depending on their goals and life circumstances. For example, though all stocks are (ideally) growth assets, some of them pay dividends to their shareholders. Dividends are a form of income you receive just because you own the stock.
Bonds produce interest income, rental properties produce rental income, and intellectual property produces royalties or licensing income.
The important thing to take note of here is that the income you receive as an investor is in no way tied to your personal labor. It is completely dependent on the asset itself – if a corporation keeps making more money than it knows how to reinvest profitably, it will sometimes rapidly increase the dividends it pays to shareholders. If you purchase bonds that help fund the construction of a new hospital system, the interest you receive may be based on the revenue that the future hospital generates.
De-coupling income generation from the time you spend working is key for financial independence. This income can either be generated by selling assets (most likely growth assets) or by holding assets that produce cash.
We’ve looked at assets from the perspective of whether or not it grows and whether it not it generates income. If it grows, that’s a great sign, and if it grows and produces income, that’s great as well!
Another thing to keep in mind when looking at potential investments from this perspective is looking at growth versus income. Even though a growth asset may not produce any income at all, it may be growing at such a fast rate that you’ll earn way higher returns than investing in an asset that produces income and grows at a more modest pace.
After all, if the asset is producing income, then it has less money that can be reinvested for future growth (this is especially true with stocks). If you are at a point in your life where you want to focus on creating additional income for yourself, focus on income-oriented assets. If you want to focus on increasing your net worth as fast as possible, focus on growth assets.
This is a spectrum, and is not a binary decision. You can invest in both! Just remember that different types of assets have different growth and income characteristics.
Now that we understand what makes an asset valuable, let’s examine the three major asset classes that we can invest in.