Recently, you heard me talk about non-traditional ways you might use extra income to build wealth. I wrote about having fun using it to fund hobbies or other enjoyable pursuits. You had to think outside the box about how you might earn money at the same time. Before that, we looked at good old fashioned spending. If you read Part I and skipped Part II, you may have already decided to spend it all(wink)! Regardless, I encourage you to read all three articles and figure out what you want to do.
The way you treat extra income will have a big bearing on your future. But, I understand it will also depend on your current situation. For the purposes of this article, we’ll assume that you have a full-time job or business. We’ll assume you have enough income to live and are not behind every month. If you’re like most people, I’ll guess you also don’t have a ton of free time. If this is the case, you’ll do well to learn about passive investments that don’t need a lot of time from you.
What is a passive investment? Think of it like a fruit tree. You only have to plant the tree once. You may have to take special care of it for the first year, but after that it should survive on its own. Yet, each year it is alive it gives you fruit. All you have to do is collect the fruit.
What fruit trees can you plant that will bring you the most fruit for your seed? You want the most bang for your buck without risking too many “duds”. Since we’re talking about investing your income, what investments work best for that?
There are enough choices out there to make your head spin. The good thing is, you don’t have to know them all. You can pick a handful of investments to meet your goals of diversification and income.
The Big Three Investment Categories You Should Know
You could spend your entire life studying investments and not know everything. You could spend a good part of your life learning just the three main categories. The good thing is, you just need to know the basics to get started.
To start building wealth, you begin with stocks, bonds, and real estate. Most people never need to go beyond these three investment types to get diversified. Each category also has its own subcategories and ways to invest. Luckily, those range from simple to complex, and you can keep it as simple as you like.
The first thing most people invest in is stocks. These days, you never even have to pick a stock if you don’t want to. You can pick a stock mutual fund or ETF, and viola, you own stock. Not just one stock, even – usually hundreds! You can pick a diverse set of a few funds, and your stock holdings are now spread out enough to reduce your risk.
To reduce risk further, add another investment type with different characteristics. The first choice for most people is to add bonds to the mix. As with stocks, you can add bonds to your portfolio without buying individual bonds. There are plenty of bond funds out there to get you the exposure you need without much effort.
Many people take their diversification one step further with real estate investments. Some people buy rental properties, and these can work much like the fruit tree analogy. But, someone does have to run the property. Meaning you’ll either have to run and manage it yourself, or hire someone else to do it. In that way, owning a rental home can be a little more active than desired.
Fortunately, there are a whole slough of other ways to invest in real estate. The most common way to receive rental income without owning a home is through a REIT. REIT stands for Real Estate Investment Trust. You can think of it like a mutual fund full of houses, or apartments. Like a mutual fund, REITS pay returns every year, split among the investors.
In these ways, you can use investment income to gradually build ownership of even more assets. These assets can produce further income, undergo capital appreciation, or both. Even if you spend some of your extra income, it’s important to put some of it into investments every month.
One advantage to investing your extra income each month is Dollar Cost Averaging (DCA). DCA helps to lower your average buy price over time. Instead of having to pick a time and a price to buy, you just buy at the same time each month. This way, you’ll get a variety of prices, some better than others. This adds value, because our emotions often reduce our ability to pick “good prices”.
Choosing prices, timing, and individual investments is not something everyone wants to do. If you decide you want to become more involved, there is a whole world of investments to explore. Stay tuned for Part IV where I will touch on those.