The Top 4 Considerations in Choosing AssetsSep 08, 2022
Have you ever wondered how people choose which type of asset to invest in? You know "diversifying" is important, but how do people do it?
Do they listen to advice from a podcast? Go with “well, it sounds good”? Maybe they throw darts at a wall?
While all of those are certainly options, some ideas are better than others; and some people have a downright scientific method of figuring out which sorts of assets to invest in. We’ll share one of those methods with you today.
4 Top Factors
There are 4 top things to think about when choosing whether or not you want to invest in a particular type of asset. The first consideration is liquidity. A liquid asset is something that is easy to convert into cash. Your bank account? Highly liquid- it’s actual cash. Your stocks are moderately liquid; it would only take a few days to sell your stocks and get cash for them. Bonds are less so; real estate is not very liquid at all.
The second consideration is safety. Is your asset subject to losses of capital? Again, your bank accounts are very safe- you have assurances that you will not lose what you deposit into your checking or savings accounts. The cash value in your life insurance is just as safe as your cash accounts.
The money you have in bonds and real estate is moderately safe- bonds can lose value if interest rates or inflation increases, and while real estate is a relatively safe investment, your property can lose value if your local real estate market is poor, if expensive repairs crop up, or even if there are too many homes on the market. Investing in the stock market is not safe at all- you have the potential to lose every penny you invest- while cryptocurrency is on the far, far side of high-risk.
The third consideration is growth potential. Most people consider “risk potential” and “growth potential” as the same thing- have you ever heard, “no risk, no reward”? People often assume that they have to trade risk for reward, but they are definitely two separate components to an investment.
For example, stocks and mutual funds both have high growth potential; but purchasing separate stocks is riskier than investing in a mutual fund. Real estate has excellent growth potential, while remaining moderately safe; and investing in market futures or a franchise can have high growth potential, but is also high-risk.
The most important thing to remember here is to evaluate risk and growth potential separately.
The 4th and final consideration to this method is tax advantage. Does this asset have any tax advantages to it? In other words, you want to pay something less than income taxes on an investment. Most investment types have some kind of tax advantage: real estate, brokerage accounts, and investing in cryptocurrencies allow you to pay capital gains taxes on your growth, which are lower than income taxes. Are you investing heavily in your 401(k) or employer-sponsored retirement account? Those allow you to take advantage of tax deferral - although remember, you will end up paying income taxes on your savings and your gains in the long run.
Tax-free vehicles include permanent life insurance and Roth retirement accounts- you never pay any taxes on any growth in those vehicles, making them the perfect tax shelters. You also pay no taxes on your gains when you invest in foreign currencies.
Other tax-advantaged investments include franchises; bonds; and options, futures, and commodities. Owning or investing in a franchise or small business allows you to take advantage of many tax deductions and other tax loopholes, while bonds allow you to avoid federal income taxes and, sometimes, state income taxes as well. Options, futures, commodities, etc fall under the umbrella of capital-gains taxes.
Note that, if you are invested in bonds, stocks, etc through your 401(k) or other tax-deferred vehicle, you take advantage of tax deferral but not capital gains tax rates as well. Uncle Sam might be able to double-dip into your pocket, but he doesn’t let you to do the double-dipping!
Rule of Thumb: 3 Out of 4 Ain’t Bad
Now that you’ve evaluated each of these 4 items separately for an asset you might invest in, what does it all mean? In general, you want to have 3 positive factors before seriously considering an asset.
Here’s an example: let’s look at your savings account. Is it liquid? 100%, so that’s a go. Is it safe? Also gets the green light. Does it grow? Not even enough to make up for inflation, so that’s a no vote. Is it tax advantaged? In no way, shape, or form. So your bank account gets two green lights, and two red lights under this method- your savings account is not a good asset to invest in.
How does permanent life insurance compare under this method? Well, it’s liquid after a certain point- let’s give that a yellow light. It’s 100% safe, so that’s great; and it grows a little bit- more than inflation but not by much, so that’s another yellow light. But it’s the perfect tax shelter, so it’s tax-advantaged. All in all, it gets a 3 out of 4 vote so yes, permanent life insurance is a good asset to invest in under this model.
How well does a 401(k) work with these considerations? Well, it’s not liquid if you’re under 59 ½ (but it is if you’re older). It may or may not be safe, depending on what you’re investing in. It’s got great growth potential, though, and it is tax-advantaged. It gets 2, maybe 2 ½ out of 4 stars.
OMG should I not have a 401(k)?! No, we’re not saying that at all- under these 4 considerations, a 401(k) is not the best asset to invest a lot of money in, but it has other awesome advantages (which is part of a different article!)
If a 401(k) isn’t perfect, how about investing in the stock market in a plain old brokerage account? Well, a brokerage account is highly liquid; it’s not safe at all, but it has high growth potential and it’s tax advantaged. With 3 out of 4 stars, it’s a great asset with this method.
Our next to last example is bonds- we’re trying to cover all the common sorts of investment vehicles here. Bonds are like life insurance- they’re liquid after a certain point. Yellow light there; they’re fairly safe, so green light for that. They don’t have fantastic growth potential, so another yellow light; and they’re usually tax-advantaged. Overall, we give 3 out of 4 to bonds, but remember- details matter, and your mileage may vary.
And our final example of a common savings/investment vehicle is real estate. Is it liquid? Not at all- the selling process can be lengthy. Is it safe? It’s not 100%-guaranteed but it is very low-risk, so we give real estate the safety green light. Does it have growth potential? Certainly! And is it tax-advantaged? Yes, in several ways- extremely cool. 3 out of 4 stars- bring on the real estate!
A Reliable Framework
These are the top types of things you might think, “Hm, is this really a good asset to invest in?” And now you have a concrete framework that you can use over and over again to evaluate the potential of any asset. Our next article is going to talk about other methods and considerations for assets- remember, your mileage may vary and the details matter!
Now That’s Smart Money 🧐
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