When it comes to investing, there’s one question to ask and answer as you make decisions on where to allocate your dollars. Will I be an owner of companies, or will I be a lender to companies? That’s it. In its simplest form, this is the one theme that must be determined by all investors.
This may not be as obvious as it seems, but it still is the most important question to ask regardless of your wealth. There is simplicity and depth to this question which is often overlooked. Before you invest, and as you’re investing, are you clear on your philosophy and approach to where your monies go? Can you articulate what you own and why, regardless of what’s taking place now? When contemplating where to deploy your dollars, it really boils down to two choices. Owning diverse companies or choosing to lend to these companies.
Owning companies may be defined by investing in equities inside mutual funds and exchange traded funds. Some investors own companies directly via stock. All companies are operated by men and women all over the globe who make daily decisions to positively influence a company’s value. How?
Some companies offer services, others offer products, and some offer both. Their goals are all the same; to create value in the eyes of their customers, continue smart growth and improvements, and not lose money. Companies that lose money become extinct or attractive targets for other profitable companies.
Companies routinely expand and contract in value, some pay dividends, and are priced based on others’ expectations. Pricing is also determined by the value companies continue to deliver to their customers. Continuing to deliver value is necessary for a company to stay relevant.
Companies run in different industries all around the world. Some are small, others massive. One consideration when owning companies is to ensure you don’t make a killing or get killed by holding just a few. So, how might this be accomplished?
Diversification is defined by owning lots of companies. I’m biased to exchange traded funds which may hold 505 of America’s best companies. Small and mid-sized US companies may be owned via exchange traded funds too, often thousands of them in a single investment. This same approach may be applied to all sized companies working outside the US.
Using historical rates of return, companies on average have returned roughly 10% +/- over many decades. It’s important to recognize over this same time frame the rising cost of life (inflation) takes a bite out of that growth. This roughly equates to 3%, so companies’ real return is roughly 7% +/- in the long run. These returns are never guaranteed, predictable, and rarely moving in a straight line. It takes patience, discipline, and an extended time horizon for results to arrive.
The alternative approach to owning companies is lending to them. Here an investor provides a company with cash to be used at the company’s discretion. In exchange, the investor receives a yield on the money they parted with and a return of their dollars at some point. Lending to companies has historically been viewed as “safer” than compared to owning them.
When an investor lends to companies, they are often seeking a less volatile path. As one can imagine, less volatility often goes with lower expected rates of return. Looking back, lending to companies has generated a roughly 6% +/- return historically speaking. After factoring in 3% inflation, real returns on lending to companies are 3% +/- over decades.
So, as an investor, would you prefer a net 7% return or a net 3% return over your lifetime? That’s really the question all investors should be asking themselves. I’m belaboring this point because I don’t believe investors are asking this particular question before selecting investments.
Allocating your investments properly requires an understanding of how your liquidity, cashflow, time horizon, and desired spending habits work together. These items often become the basis of a financial plan which may supply guidance on where to invest, including the decision to own or lend to companies.
Advisory services through Cambridge Investment Research Advisors, Inc., a Registered Investment Advisor. Cambridge and Flowerstone Financial are not affiliated.