Back in business school one of the first and last lessons you learn is how to read financial statements. Company after company, year after year, the format and calculations on these financial statements stay the same, and this continuity gives us the ability to compare companies to companies and a company to itself as it grows or declines over time. Central to these financial statements you will find the income statement and, more important to our discussion here, the balance sheet.
It is on the balance sheet where investors are able to get an at-a-glance view of what a company owes and owns. The balance sheet operates under this crucial assumption that sits at the foundation of accounting:
assets = liabilities + shareholder equity
In other words, everything a company owns (their assets) are provided by either taking on debt (liabilities) or from money provided by the company owners (shareholder equity). We could similarly make a balance sheet for the business that is your life that would look a little something like this:
assets = debt + income
In other words, everything you own (your home, your car, your rolling pin, and your power drill) is provided by either debt that you accumulate or income that you generate. In most cases the income generated comes from hours you invest in the labor market, and your debt comes from mortgages, loans, or credit cards.
The key to a corporation keeping a healthy balance sheet is to have the right balance of debt versus equity to then invest in the right mix of assets that will grow a company’s worth over time. If a company squanders the money away by investing in things of little value, then they go bankrupt. On the other hand, a company could invest in the right mix of people, procedures, and technology that then generate income for the shareholders. Think about this in the context of your life. You take on debt and you generate income. What kind of assets are you investing in? Do you squander your money on things that don’t have much value or are your assets making you money all on their own?
Imagine What Would Happen
As a marketer, I am well aware that consumers like me and you spend money as a “goal setting” activity. In other words, we spend for the lifestyle we want to have instead of the lifestyle we actually have. Let’s take a moment and explore what would happen if, instead, we made saving money, and then investing that money in “income generating assets”, as our goal setting activity instead. Imagine what would happen if instead of using your income to buy things with little long term value you instead used them to purchase assets that actually make money for you passively. Imagine what would then happen if your monthly income from these income generating assets exceeded your monthly spending. That, my friend, is just another way of explaining what it is to retire.
Let’s find out a little bit more about income generating assets and then explore some investment options.
All About Income Generating Assets
Income generating assets are defined as investments that you make that then generate passive income without active participation on your part. Here let’s explore three more commonly known income generating assets and then compare them to some lesser considered assets.
Savings Account: When you save money and put it into a bank you are inherently purchasing income generating assets. However, with an average return of just 1.05% (meaning you essentially make $1.05 for every $100 you have in a savings account every year), you have not purchased assets that will generate much value over time. In fact, you are actually losing money since the $1.05 you earn can’t catch up to the $3.00 you lose with the rise in cost of living (otherwise known as inflation, which historically sits at about 3%).
Bonds: Bonds are an income generating asset that are popular with those that are highly risk averse. Bonds are basically loans, but, in this case, you are the bank and you are the one lending money. U.S. Treasury Bonds are a common investment among the risk averse because, as much as talking heads like to postulate about it for ratings, the U.S. government isn’t going anywhere and will, therefore, be around to pay back on their debts. You can typically get a return of about 3% on these bonds, which right now just ensures that you don’t lose money against the fight with inflation.
Stocks: Here you have the most popular financial instrument in the world. A stock is a share of ownership in a company. If you own shares in the company, then when that company makes a profit you will also profit in the form of a “dividend”. On the other hand, if that company invests poorly, then you can likewise lose the money that you invested making them inherently more risky. You can’t lose more money than you invested because the balance sheet will always balance. The key to managing risk with stocks is to diversify, and my favorite way to diversify is with mutual funds and my favorite mutual funds are low cost index funds. Index funds are low cost because they don’t need a group of Ivy League hot shots managing them for the best return. Instead, you have assets like the Nasdaq index fund, which basically just invests in the same set of stocks that the Nasdaq is indexed against. You can also get an an index fund based on the S&P 500. As you would imagine, if you have these index funds and the market goes up, then your income goes up as well. If you own these funds when the market goes down, then your income goes down just the same. In the long term the market trajectory goes up as does your own income. Return varies with risk. I have a moderate risk portfolio where some funds pull in 8% and others over 10%.
Real Estate: Here we enter the realm of investment properties. When you buy a piece of property you can then rent it out, and that rent then becomes income to you. Easy enough. Another way to invest in real estate is through the purchase of “mortgage backed securities”. These were the investments that had a big part in the 2008 financial crisis. Similar to a bond, when you own a mortgage-backed security you are, essentially, buying someone else’s property in the short term and they pay you back for it with interest. In order to diversify, when you own a mortgage backed securities you actually own itty bitty portions of thousands of people’s homes, essentially. That is supposed to make the investment less risky for you because while it would be possible for one person to default on a mortgage it is far less likely that thousands of people would default on their mortgages all at the same time. Unless, of course, the lending industry is selling mortgages to thousands of people that can’t actually afford the homes they are buying. That’s the mistake that broke this country’s back. Income generated from both rental properties and mortgage backed securities rise and fall with the housing market, but either producing a 10% return is not uncommon.
Crowdfunding and Crowdlending: This is a newer entrant into the income generating asset pool. Remember with mortgage backed securities how you were buying itty bitty bits of the properties owned by thousands of people? With crowdfunding you are joining the ranks of many thousands of other small investors and owning an itty bitty (or a lot a bit) of a start up company. With crowdlending you are similarly joining the ranks of others to loan money to people in return for interest on that loan. Sometimes these loans are similarly bundled up like a mortgage backed security. However, the risk with these types of income generating assets are that they are not “secured” in the way that old school investments are, which means the lender is relying on the borrower to pay what they said they were going to pay. To their credit, though, the default rates for crowdfunding and crowdlending have been low. Common returns are between 6% and 9%.
Renewable Energy: Speaking about assets that generate income without talking about renewable energy would we shortsighted. When you own sources of renewable energy, be they solar panels or wind turbines, you own assets that generate energy and energy generates income. Another plus is that investors in renewable energy are being subsidized by the government for these investments. That means that the government is essentially providing some of the money that is then used to purchase your income generating assets. Because of this shared investment, investors in renewable energy have received returns higher than 20%.
There is quite a bit of diversity out there for those looking to invest their savings in income generating assets. Hopefully this discussion broadened your awareness of the possibilities available to strengthen your own personal balance sheet.