There are two basic sources of money for investing–your own money and other people’s money (so-called OPM). Your own money can come from sources as diverse as cumulative life savings, your most recent paycheck, and dividends and profits from your own investing. Common examples of OPM, used for both investing and consuming, are credit card debt, car loans, real estate mortgages and loans or investment capital that can come from family, friends and others in partnerships.
Getting Started With Your Own Money
Often in life, what’s most important is getting started on the right foot. In the case of investing, this means putting some money aside, however small, and setting up a suitable investment program for yourself.
To extract “seed capital” for investing, the place to start is with your own personal income statement. You need to arrange your personal finances, so that your income from all sources exceeds your total expenditures. Practically speaking, this usually entails a combination of elements such as:
Income Side: Finding a job that pays better, asking your boss for a raise, saving the incremental pay you receive from your next raise, taking a side job to earn extra income, saving any money gifts and cash bonuses you receive, training (or retraining) yourself to work in an occupation that offers a higher salary, etc.;
Expense Side: Moving into a house or apartment that has lower rent, finding a roommate, renting out rooms in your own house, driving a reliable but affordable car, going out to eat less frequently, spending vacations closer to home, looking for sales when shopping, buying necessities and not luxury items, etc.
The point is that you’ve got to figure out a way to save some money that will serve as the “seed” to start investing. You might think that $100 or $1000 is “small money,” particularly if your financial dream is to become a millionaire, multi-millionaire or billionaire. However, for the sake of your own long-term financial health, you must, as early as possible, establish personal habits that are conducive to wealth-building. In my opinion, successful investing really begins with having the discipline to “live within your means,” spending less than you earn and thereby continually augmenting your investment capital. Once you are a prudent manager of your own personal money, you can begin to supplement your investment portfolio with other’s people’s money.
Using Other People’s Money
Having access to sources of money other than your own, which typically means borrowing or using OPM to leverage your own capital, can potentially produce higher investment returns. Some authors (like Kiyosaki, as you cite) make a distinction between: “good debt,” like a mortgage on rental property, which can be serviced using rent paid by tenants; and “bad debt,” like an auto loan, which you might take out on a new car and now have to service with your own money. Others distinguish between good debt on appreciating assets, like real estate and stocks, and bad debt on depreciating assets, like cars and elegant wardrobes. Still another useful point of view is that good debt produces cash flow, while bad debt does not.
To these dichotomies between good and bad, I would add a measure based on lowest cost of capital:
Good debt is necessary borrowing within reasonable risk limits at the lowest available cost of capital, regardless of source, so long as the expected return on your overall investment portfolio exceeds your cost of capital. Bad debt is borrowing that doesn’t meet the specified good debt requirements.
Here are some examples to help illustrate:
New Graduate in New Job: You’ve recently graduated from college and taken a career-oriented job. Your income from work is enough to cover your rent and living expenses, make payments on your student loan, and save a few hundred dollars each month. You are eager to start investing in stocks, have faith in Steve Jobs’ leadership, and want to buy Apple (Nasdaq: AAPL), thinking that the stock will continue to rise on the strength of the company’s newly released iPhone and upcoming lower-priced model. Your available sources of investment capital are: $2000 in a savings account, a cash advance on your credit card at 18% interest, or a private loan from a friend who says you can pay him back in a year with interest in arrears at 10%.
My suggestion: Continue to save what you can from your paychecks. In a year’s time, when you have a few thousand dollars more in savings, reconsider making the proposed investment if you still have the same outlook on Apple’s business prospects. Neither the 10% private-party loan nor the 18% credit card loan is attractive, since your investment return could easily fall shy of these levels if Apple’s sales or earnings falter or the stock market sags on unencouraging macroeconomic news. Also, you ought to maintain a few months’ living expenses in your savings account, as a buffer against unpredictable changes in your job situation. Be patient. During the upcoming year, you might find even better investment opportunities than what you are seeing today.
Homeowner Buying a Car: Suppose you are buying a factory-certified, pre-owned Toyota Prius, since your gas-guzzling minivan has blown an engine gasket and you are in dire need efficient wheels to get around. To pay for the car, you have three choices: sell $15,000 of stock or other investments, borrow on your home equity line at 8% APR, or take out an auto loan at 7% APR. Based on the bad-debt-on-depreciable-asset thinking, you would eliminiate the auto loan from consideration. The bad-debt-if-you-have-to-service-it-yourself thinking would knock out the home equity line choice as well, leaving only the investment liquidation alternative. But you don’t really want to sell stock that you currently own, since you feel confident that you can continue to achieve returns higher than 7% on your investments, since you’ve been averaging 10% over the past seven years, through both down (2000-2002) and up (2003-2006) markets.
My suggestion: Assuming you are comfortable with the additional portfolio leverage and have adequate cash flow to cover the debt service payments, take out the auto loan, since at 7% it is your lowest available cost of capital and is lower than the 10% return you expect on your investments. Think of the auto loan as not a wasteful loan on a depreciable asset but as your most efficient way to borrow funds within the context of your overall portfolio.
Investor Considering Second Mortgage on Investment Property: You have been out looking for investment property and have found a $500,000 apartment building that looks attractive and will, at 75% loan-to-value, provide positive cash flow with an expected 10% total return. Banks will lend only up to 65% loan-to-value ($325,000), and you can take out a second mortgage for the remaining 10% ($50,000). The interest rate on the second loan is 9%. You may alternatively tap your home equity line at 8% interest to come up with the remaining $50,000 needed to buy the apartments.
My suggestion: Even though the home equity line directly involves payments that you will have to make on your house instead of on the apartment investment, it is your lowest available cost of capital. Therefore, go ahead and tap the equity line on your house, and proceed to make a back-to-back loan into your investment property with terms matching your home equity loan. By effectively transferring the financial burden from your house to your investment property in this way, you achieve your lowest cost of capital and optimize your expected investment return on an overall portfolio basis.
Crossing the Finish Line
Investment capital, then, comes from a combination of your own money and other people’s money, with the mix depending on your situation. A few key tenets to keep in mind are:
Savings: Anyone who is seriously interested in starting to invest ought to be able to save some money. Even putting aside just $100 a month is enough to begin to accumulate significant capital for investing.
Patience: However eager you may be to begin buying stocks or real estate, realize that market opportunities will change but will not go away. Getting started a year from now with investment amounts and risk levels that suit your own financial situation is better than rushing to get started today with excessive leverage or using other people’s money on terms unfavorable to you as borrower.
Risk Management: So much of successful investing is risk control. Of course, we all seek higher returns, but knowing how much and on what terms to borrow is important. Do not borrow at rates that are higher than you can honestly achieve through your investments.
I think it is helpful to view investing as a life-long race in which you lead with your own money and add, as follow-on, other people’s money when you can do so prudently. Relying solely on your own money, you may end up growing your net worth more slowly but you’ll never go bankrupt and you will finish the race. At the other extreme, relying too much on OPM, you could grow rich quickly, but you also run the risk of losing it all and never crossing the finish line. Ultimately, the art of successful investing involves pursuing the optimal path at each stage, walking the fine line between too conservative and too aggressive.
posted by Lloyd Sakazaki