LEARN HOW TO INVESTGUIDE FOR BEGINNERS: Module 9
Michael Santos Presents
Understanding Alternative Investments
Improve your understanding of alternative investments, then use your knowledge in business to invest in new markets.
Using your knowledge of business to invest in new markets
Alternative investments differ from what we covered in the previous chapters. I developed the story of Liberty Hot Dogs to give beginners insight into starting a business. Participants learned about sole proprietorships, partnerships, LLCs, and corporations. They learned how to form a business, how to raise capital, how to use financial statements to track capital, and how to grow the business. We then briefly discussed exiting the business, from taking distributions, to selling to private equity or to the public markets.
By understanding business, we position ourselves to understand all types of investments. Traditionally, people think about investments as stocks and bonds, or investment vehicles that relate to the stock market or bond market. Those are the types of investments that go into traditional retirement accounts.
In this chapter, we’ll discuss:
- Retirement Accounts
- What Are Alternative Investments
- Examples of Alternative Investments
Retirement accounts allow people to invest with pre-tax income. Most large corporations offer retirement accounts to their employees, and many match a portion of the employees’ contribution to the retirement account. For example, if an employee agrees to contribute $100 from each paycheck to the retirement account, the employer may contribute an additional percentage of that money to the employee’s retirement account.
By contributing a portion of each paycheck into the retirement account, a person gets the advantage of consistency. Also, the investment comes from gross wages rather than net wages.
Let’s create a simplified example to illustrate.
Tom earns a gross income of $4,000 each month from his employer. The government taxes Tom at the 25% tax rate. Without deductions, Tom contributes $1,000 from each paycheck to taxes. He takes home $3,000 in pay. He can use that take-home pay for anything he likes, including living expenses and investments.
Tom earns a gross income of $4,000 each month from his employer. The government taxes Tom at the 25% tax rate. Tom chooses to contribute 15% of each paycheck to his retirement account. Each month, his employer takes $600 out of his paycheck and diverts those funds to Tom’s retirement account. The employer matches 20% of Tom’s contribution, or an additional $120. Each month, Tom’s retirement account gets a total infusion of $720 (the $600 Tom contributes, plus the $120 from the employer’s matching contribution.) That entire $720 is contributed without any tax being taken out. Tom’s effective pay is then $4,000, less the $600 that he contributed to his retirement account. The government still taxes him at 25%, but the government is taxing 25% of Tom’s $3,400 in taxable pay rather than the $4,000 that he earned. Under this scenario, Tom is paying $850 in tax—rather than $1,000 in tax.
The obvious advantage is that Tom’s has a systematic contribution to his retirement each month. Further, Tom’s employer is contributing additional pre-tax money to his retirement account. Theoretically, those regular contributions will result in Tom’s retirement account growing substantially over time.
USE OF RETIREMENT FUNDS
When Tom opens his retirement account, he may also choose a plan. The most common plans include funds that expose Tom’s retirement account to either the stock market or the bond market, or a combination of both. Tom may choose which type of exposure he wants, including:
- Tom may choose to invest aggressively into funds that are riskier, but have higher potential for upside.
- Tom may choose to invest conservatively into funds that will grow slower, but have lower potential for downside.
The funds that Tom accumulates in his retirement account will be restricted. The account may grow or may fall in value, depending on how the assets in the account perform. But Tom will not be able to access funds in the retirement account until he reaches a specified retirement age. In some cases, he may be able to borrow against the retirement account. The play may charge him a penalty if he withdraws from the account before he reaches retirement age—he may have to pay taxes and penalties.
When Tom reaches retirement age, he would begin to make systematic withdraws. For example, Tom may choose to begin living on his retirement account when he turns 65. Each month, he may take a distribution of $5,000. He would pay his tax on the amount of his distribution. The rest of his money would continue to grow.
Make Sure You’re Prepared:
Retirement accounts serve many people well. But investors should remember a few things about a retirement account:
- Traditional retirement accounts correlate to the stock market or bond market.
- The stock market has grown over time, but it can be volatile.
- The bond market is safe, but it pays minimal interest.
- Funds in the retirement account will not be accessible until the account holder reaches retirement age, bringing the potential for lost-opportunities.
Statistics show that most people do not take the initiative to prepare for retirement. According to a May 14, 2018 CNBC article, 67% of Americans anticipate that they will outlive their retirement savings.
Investors who want to prepare for retirement may want to educate themselves on alternative investments. With self-directed Independent Retirement Accounts (IRAs), investors may invest their pre-tax dollars into alternative investments. They would have the same age restrictions, but they would have more options to consider how to invest their money.
What Are Alternative Investments?
An alternative investment is something different from an investment in stocks or bonds. Stocks and bonds are traditional types of investments. In most cases, traditional investments are more liquid, meaning investors can convert them into cash with relatively short notice. They may pay penalties, or sell into a down market, but they can convert the investment into cash quickly.
An alternative investment, on the other hand, may require a longer time horizon to convert to cash. Some examples of alternative investments include:
- Investing in art that we expect to appreciate in value.
- Investing in gems or jewelry that we expect to appreciate in value.
- Investing in vintage automobiles that we expect to appreciate in value.
- Investing in wine that we expect to appreciate in value.
- Investing in real estate that we expect to appreciate in value.
Like any investment, an alternative investment is only worth what the market is willing to pay. If there is a high demand for the asset, investors will raise their prices. If the asset doesn’t have much demand, the asset may fall in value.
Why Choose Alternative Investments?
People may choose to make alternative investments for a number of reasons. For example:
- An investor may choose an alternative investment because he wants to minimize exposure to a volatile stock market.
- An investor may choose an alternative investment because he wants to generate a return that is higher than he would receive from the bond market.
- An investor may choose an alternative investment because he wants to diversify holdings.
- An investor may choose an alternative investment because he believes he can get higher exposure to upside, with lower exposure to downside.
Investors who understand business may see the value in alternative investments. For example, consider the price that investors are paying for individual stocks like the two we discussed in the previous chapter.
- Microsoft, one of the most valuable and respected companies on the planet traded at $106 a share on November 2, 2018. At that price, investors were paying 51 times the earnings of Microsoft, for a total value of $814 billion.
- Netflix, another well-respected and valuable company traded at $309 a share on November 2, 2018. At that price, investors were paying 110 times the earnings of Netflix, for a total value of $135 billion.
It may be difficult to understand those numbers. But if we apply those valuations to Liberty Hot Dogs, which earned $1,500 a year, we get a better idea of the risks. At the same 110-times-earnings that investors are paying for Netflix, Liberty Hot Dogs is worth $165,000!
Obviously, no investor would pay $165,000 for a hot dog stand that generates total profits of $1,500. But investors do not hesitate to pay that high multiple to invest in Netflix.
Look at All Signs
As investors, we should consider these signs. They help us determine whether markets are healthy, or ripe for a correction.
These examples provide a snapshot on investing, and I admit it is a simplified snapshot. Investors pay a high multiple for Netflix because they expect the company to continue growing. As the company grows, profits will grow. Investors are paying for the promise of upside. They want to be a part of a proven, profitable company.
But are they paying too much? Is the stock market overvalued today?
Only time will tell. The right investment at the wrong time is the wrong investment.
Here is what we know:
- In 2007, the Dow Jones Industrial Averages traded at more than 14,000 points.
- Then the recession hit.
- The Dow Jones Industrial Averages fell to less than 7,000 points.
- In 2018, the Dow Jones Industrial Averages traded at nearly 27,000 points.
As investors, we must consider our investments will perform as well over the next 10 years as they have performed over the past ten years.
The Dow Jones Industrial Averages is more than 20,000 points higher than it was at the recession lows, ten years ago. That is nearly three-times higher!
- Is it likely that the market will continue to grow at the same rate over the next ten years?
- Is it more likely that the market will suffer a correction, and drop in value?
- Does it make sense to consider alternative investments that will minimize my exposure to that potential volatility?
Case Study: Using Alternative Investments to Build Prosperity
Investors who understand business may feel more confident to adjust their investment portfolio. If an investor thinks in ten-year time horizons, the investor will make adjustments along the way. Some of those investments may go into assets that do not correlate directly to the stock market. Our investments should harmonize with the goals that we are striving to achieve, and with clear time horizons.
When I concluded 26 in prison, I was 49 years old. I set a clear goal of acquiring $1 million in assets within five years. As mentioned in one of the earlier chapters of this course, I perceived several options, including:
- I could have invested in my career, trying to create wealth through wages.
- I could have invested to build a startup business, trying to create wealth by building the business.
- I could have invested in the stock market, trying to create wealth by trading or speculating in stocks.
- I could have invested in real estate, an alternative investment.
By considering several factors including:
- My age and tolerance for risk
- My goal of building $1 million in assets within five years
- My potential for income and earning capacity
- My strengths and weaknesses, given the length of time that I served in prison
I concluded that the best option for me would be to invest in real estate. With real estate, I would have the highest access to leverage. With a little bit of money, I could control a much larger asset. If that asset appreciated in value, I would prosper—provided that I could meet the obligations associated with controlling that asset.
Considering all factors, I began to invest in real estate in California. In the next chapter, I will describe the strategy that worked for me. Beginning investors may find some takeaways in that story.