How can you invest in something new if you follow the Golden Rule of investing only in things you know about? This is a fundamental wealth-building problem, a problem that I suggested two solutions to in the past: (1) that before you invest in a business, you get to know it by working for it and (2) that you invest in a business that is at least 50% similar to a business you are already in. Obviously, if you limit yourself to these two options, you won’t be able to invest in most stocks, certainly not mutual funds, and you will only rarely find a private deal (a limited partnership or an equity interest in a start-up company) that passes muster.
Making Friendship Pay
Here’s a third way. If you have a very close friend, someone you can completely trust, who invites you to take an interest in a business he knows (and has been successful at), you might be OK. I’ve done this many times. It hasn’t always paid off, but I’ve never had to wonder if I had been cheated: a very unpleasant line of thought. If you invest with a true friend, he will bend over backward to be fair with you. Just as you would for him. Case in point: Several years ago, EP, an old high-school buddy I’ve stayed close with for about 15 years, invited me to invest in his real-estate-development business. I didn’t know anything about real estate at the time, but I knew he did. I figured if I could invest a reasonable portion of my investment capital with him, ‘Id have a good chance of making a fair return and a very good chance of learning something about the business. And I have — profited and learned. The ROIs have varied depending on the particular deals, but I’ve acquired invaluable knowledge about how these deals are done . . . and about how real estate is sold. So much so that I’m beginning to do some stuff on my own. With EP, I had several factors in my favor: 1. He and his partner had an established track record. It didn’t just look good on paper; it was real. (I had spent plenty of time with EP. I knew what kind of money he was making.) 2. I knew EPs former partners, and not one of them was angry with him. 3. The contract he gave me had my money coming out of the deal before his did. (That’s something you should always ask for as a limited partner.) 4. In addition to the money, there was something else I could contribute to the partnership — marketing know-how. This would make me valuable in the eyes of EPs partner, who was a nice guy but not a close and trustworthy friend. But the key reason for my going into business with EP was that I knew he would do everything he could to take care of me. He couldn’t control the ultimate economic outcome of the business, but he could — and has — controlled the integrity of the deal. Its way too easy to lose money in a private investment. As an outside investor, there is just too much you don’t know. It doesn’t matter how much business experience you have in your own field, how many degrees you have in business, or how much you study the business press. If you don’t know the particular industry you are investing in, you will never be able to control all the many ways you can get screwed. There’s an old saying in the partnership industry: “When two guys go into a deal together and one has the money and the other has the knowledge, the guy with the knowledge will end up with money and the guy with the money will end up with knowledge.”
The Biggest Risk When You Invest With A Friend
There is a significant hazard in doing business with a family member or friend. You risk the relationship. To make such a deal work, either you both have to be the type who would sacrifice the business proposition to maintain the friendship, which is a rare thing, or you both have to be mature enough not to allow personal feelings (especially negative ones) to have any role at all in the business relationship.
Buying Experience Shrewdly
If you are not lucky enough to have friends who have good business opportunities for you, there is still one more way to invest in a business outside your field of expertise — find a very promising entrepreneur and buy a controlling interest in his company. This is tricky, but it can work. The idea is that you buy at least 51% of a business that you like that is run by someone whose intelligence and work ethic you admire. To make such an arrangement work, you need to fix the fixed portion of his compensation at a level he is not comfortable with. His real income should come from profits, and he should be confident enough in his own abilities and in the economics of the business (which you know little of) to take the chance of earning less than hed like to (or has). His upside should be considerably higher than it would be without your investment capital, but his downside should be considerably lower. You want him to work as an entrepreneur, not as an employee, because it will be he, not you, who will make the business work.
What Else Can You Do?
Other than those types of arrangements, I would discourage you from investing in individual businesses (either by buying stock or by direct investment) that you don’t know. This is a radical thing to say these days, when everyone has a stock portfolio, but its simply too hard to learn from reading what you need to know to learn from experience. If you believe in the stock market, invest in index funds and municipal bonds. The bottom line is this: I don’t believe you should invest in things you don’t understand. And I don’t think you can understand a business by reading about it. When it comes to business, the only knowledge that matters is that gained through experience. Until you have it, hedge your bets by following the guidelines I’ve suggested.[Ed. Note. Mark Morgan Ford was the creator of Early To Rise. In 2011, Mark retired from ETR and now writes the Palm Beach Letter. His advice, in our opinion, continues to get better and better with every essay, particularly in the controversial ones we have shared today. We encourage you to read everything you can that has been written by Mark.]