Wealth Building Secret #4: Invest In What You Know

“The first man to fence in a piece of land, saying ‘This is mine,’ and who found people simple enough to believe him, was the real founder of civil society.” – Jean-Jacques Rousseau (Discourse on the Origin and Bases of Inequality Among Men, 1754)

Yesterday, I explained my approach to balanced investing: Divide your investing into four categories:

1. your home

2. loans backed with collateral

3. investments in conservative stocks

4. investments in a high-yield business opportunity

The first three-quarters of your invested wealth will appreciate slowly, steadily, and safely. As a group, this portion — the lion’s share of your net worth — will ensure that you can honor that commitment you made to yourself: As time passes, month after month and year after year, you will always be getting richer, never poorer.

Another important characteristic of this portion of your investments: It doesn’t require you to actively manage it. Although it’s possible to get a somewhat higher yield (ROI) by actively trading stocks and bonds (and even your home, for that matter), I don’t recommend it.

I believe you’ll do better in the long run by leaving these investments alone. Take time choosing them to begin with, but then leave them alone for 10 or 20 years — until you move into another phase of your working/playing life. Take the time you’ll save by not actively managing your home, your bonds, and your index funds and invest it in the management of the fourth portion of your investments: a high-yield business opportunity.

Let’s talk about high yields.

We said yesterday that the basic rule for investing is this: The higher the return, the more risk you must be willing to take. That is generally true. But there is one important way to slash your risk to the bone, even on some relatively risky investments: to know — really know — what you are doing.

No matter where you put your money, you will get better returns in the long run if you select investments you understand — and if you continue to learn more about those investments for as long as you are investing in them. To get the greatest yield with the “active” quarter of your investment portfolio, you need to invest in something you are committed to knowing about.

What types of investments are appropriate for this portion of your savings?

Glad you asked. In my view — and this is an opinion that won’t find much support among financial planners and stock gurus — you should probably not put your high-yield money into such traditional high-yield investment vehicles as futures, options, micro-cap stocks, precious metals, and currencies. I could go on, but you get the idea: Don’t invest in risky investments unless you intend to become an investment expert. Most people don’t have the time or intelligence for that. I certainly don’t. And most of the world’s wealthiest people don’t either.

You may be the rare exception. If so, learn about day trading or hedging or spreads, etc. Figure out how to make money on covered calls and micro-spreads and the like. But if you are not a natural financial genius and you already have the distraction of a full-time job, I recommend you invest your money in something that you can learn about on a part-time basis.

Because it has made more money for more people than any other investment and because it illustrates the principles of high-yield investing, let’s look at real estate — my No.1 choice for this kind of investing.

The wonderful thing about real estate is how quickly it seems to expand. You buy a condo this year with the cash you got back from last year’s taxes. It’s barely enough to get you to closing, but you throw some extra dollars at it and fix the property up. Eventually, as your rent increases to match the property’s appreciated value, what was a net cash expense becomes a net cash positive.

Year after year, you purchase more and better properties. Some you keep for the long haul. Others you sell for a profit and then invest that money in two (or more) up-and-comers. You develop an intimate knowledge of the market. You can see the specs for a property in a given neighborhood and, sight unseen, know just how much you should pay for it. You learn to separate your feelings from your actions. You buy value and you sell into a rising demand.

Before you know it, five years have passed. Then 10. And then 20. One day, you add it all up and realize you have accumulated more than $10 million worth of real estate. What seemed like a part-time hobby has become in retrospect a retirement windfall.

I strongly recommend real estate as your active investment, but I do believe you can do just as well in other fields. I know people who have made a ton of money by buying and selling new or antique cars, boats, rare coins, new or antique furniture, small or not-so-small businesses, receivables (money brokering), antique or contemporary jewelry, baseball cards, stamps, rare books, antique or modern weapons, museum-quality art, decortive art, wine, and various other commodities.

The secret is always the same: Knowledge is everything. It will make it much less likely that you’ll overpay and virtually impossible that you’ll undersell. It will force you to develop contacts that will increase your supply of the good stuff at the best prices. It will keep you from making the big costly mistakes novices make. In short, it will make you an insider.

Until you are an insider, investing is a crapshoot. That’s why I recommend balancing the rest of your portfolio between a carefully selected home, fixed-rate debt instruments, and conservative stock funds.

I am recommending real estate because I know it works and I can tell you the most about it. I’ve been doing it for 20 years, and it has given me an average ROI of more than 15%. That kind of return can make a very big difference over time. It can easily be the difference between ending up with a “retirement” fund of only $500,000 vs. one of $2 million or one of $2 million vs. one of $8 million. I’m going to talk to you more about the specifics of real-estate investing next week. So if you decide that real estate is for you, you’ll be interested in my recommendations.

For today, make up your mind that you will do the following:

1. Save at least $12,000 this year.

2. Save more than that next year and still more in each year that follows.

3. Invest a portion of those savings in an inexpensive home in a promising neighborhood.

4. Invest another portion in municipal bonds (or another fixed-rate debt instrument).

5. Invest a third portion in an index stock fund (or in a balanced portfolio of truly conservative stocks).

6. Invest the final portion of your savings in something you can actively buy and sell — such as real estate.

Remember, when it comes to the active portion of your investment portfolio — the part that will bring you the highest returns at the lowest risk — knowledge is everything.