Having been a reader of personal finance and financial independence for a long time, much longer than this blog has been in existence, I’ve come across various beliefs that masquerade as self-evident truths, when in reality they couldn’t be farther from the truth.
This post is a list of those postulates.
No, we don’t: Confuse Assets and Investments
The terms Assets and Investments are often used interchangeably, but there are distinct distinctions between them.
An asset is an item of value, that
a) a large section of the population agree holds its value, over time
b) a smaller sub-section of the population hopes increases in value, over time
An asset has no intrinsic value, other than what you paid for it, and what someone will pay for it when you sell it.
An investment, on the other hand, has some intrinsic, underlying value.
When you make an investment in stocks, you are essentially giving the firm capital to use in some endeavors that will potentially generate more value than the capital itself. They could be using that capital for R&D to make a new product; they could be using the capital to build more plants to produce more goods; they could be using the capital to hire and train more professionals to tackle a complex problem. You, the investor, gains when the firm does well, in terms of stock appreciation and/or dividends.
There is something called the Discounted Cash Flow (DCF) analysis to determine the Enterprise Value (EV) of the company. From the EV if you take away the debt owed and the cash in hand, you arrive at the equity value of the company. This equity value of the company divided by the number of outstanding shares, leads to the “correct” stock price. Check out this video by Aswath Damodaran, professor at NYU Stern, one of the foremost minds on Valuation.
Similarly you could be investing in rental properties. These will generate cash flows from the rent you receive. You will invest money (capital investment) when you buy the properties and then when have to replace the big ticket appliances. Over time, the steady cash flows will far out score the investments you made and you pocket nice profits.
Keep in mind the fluctuations of the markets and the seasonal changes in renting units are temporary. If you have a simple, robust, and well thought out investment plan or business plan, over the long run you will succeed.
At least theoretically. There’s a saying that the markets can remain irrational longer than you can remain solvent!
Now contrast that with buying an asset such as gold. The value of gold depends on supply and demand. Gold, in and of itself, is not adding value to the money you spent in buying the bullion.
So, gold is not an investment. It is an asset.
Similarly, the home that you live in is not an investment. It is an asset, probably the biggest asset you own. You hope the price of your home goes up. In most of modern US history, the values of homes have gone up. Supply, demand, the condition of your immediate neighborhood, the broader national economy, demographic changes – all play a part in determining the value at any given time. Your home is not adding value by itself. If anything, you are spending more money to beautify your home by a kitchen remodel or by sprucing up the backyard!
No, we don’t: Call our personal vehicles Assets
Personal vehicle don’t count as Assets. The reason for this is simple. A car depreciates over time, that is, lose value as time passes. This defies the first tenet we’ve talked about Assets above. Now, not everything that depreciates over time can have the label asset removed from them. If vehicles are used for business purposes they fall under assets. They can be depreciated on the useful life value. In business accounting there is something called PPE – Plant, Property, Equipment, and they are treated as Assets. Here we are talking about personal assets.
No, we don’t: Strategize to beat the market
We are happy to get the return of the overall market. There could potentially be an investment that will generate a return greater than the market, but to correctly 1) Identify them, 2) Time the entry, 3) Time the exit – all these 3 events happening successfully on a regular basis ….well, that’s more along the lines of speculation for us. We follow the simple and sage advice of investing in broad market based, passive funds.
We actually do own some shares for a few individual stocks. First, they constitute about 2% of our overall investment portfolio, and second, we acknowledge them as speculative bets.
Readers: Any other BS that pass off as sage advice we might have missed?