How to Get Rich from Your Investment Portfolio
Making Money from Your Investment Holdings Can Happen In One of 4 Ways
For a significant minority of investors, the objective of building an investment portfolio is not simply to attain financial independence but, rather, to get rich; to have enough money to do anything they want, whenever they want, while establishing generational asset transfers through structures such as trust funds and family limited partnerships so their children, grandchildren, and in some cases, great-grandchildren, enjoy affluence or wealth from stocks, bonds, real estate, private operating businesses, and other assets dispersed throughout the family tree.
It's not an easy task but it is one that millions of people have accomplished. (To help you determine what "rich" means to you, read How Much Money Does It Take To Be Rich?)
At the core of the process of getting rich from your investment portfolio is generating income; actually making money, putting that money to work in additional productive assets, then, like the instructions on a bottle of shampoo, "Wash. Rinse. Repeat." Given enough time, the power of compounding works its magic and soon your money is making more money than you could have ever imagined. In this article, we're going to take sort of a broad-based, academic view of the different mechanisms through which a portfolio generates surplus cash for the owners of the capital to enjoy.
#1: Earn Interest Income on Money You Lend
Some investors lend money directly. One of my grandmothers spent years building her savings nest egg and then, a decade or two ago, began directly underwriting mortgages to high-risk borrowers, securing the promissory notes by the underlying property, often at rates around 13% per annum.
She only operated within a small range of communities and towns with which she had been familiar for more than 70 years. In many cases, she would either sell the promissory notes to banks once payment history had been established or she would get refinanced out of the deal once the buyer was able to qualify for a traditional mortgage.
In effect, she was "renting" her money to people who needed it to buy a home. She controlled her risk and kept a large enough portfolio of these properties that when one of them inevitably went into foreclosure, which happened from time to time, she faced no hardship until the process was completed.
Other investors prefer to invest in bonds issued by municipal governments, corporations, or other entities. These bond issuers then use the money raised to build factories, schools, hospitals, police stations, expand into new markets, launch advertising campaigns or whatever other purposes were mentioned in the bond offering prospectus. If all goes well, the bond owner receives interest income checks in the mail -- or, these days as is more often the case, directly deposited into a brokerage account or global custody account -- until the bond matures, at which point the entire principal is repaid and the bond ceases to exist.
#2: Collect Cash Dividends from Businesses You Own in Whole or Part
When you buy a business, whether you are talking about the corner drug store or a piece of a much larger conglomerate, such as a share of stock in Berkshire Hathaway, United Technologies, or General Electric, you have a chance to collect cash dividends.
This money represents part of the profit that the company's Board of Directors decides to mail out to the owners based on their total stake in the business. The more equity (ownership) you have and / or the more profit a company produces, the higher your dividends are likely to be.
As of August 2016, a share of McDonald's Corporation, the world's largest restaurant chain, pays $3.56 in cash dividends per year. If you own 100 shares, you'll receive $356. If you own 1,000,000 shares, you'll receive $3,560,000. These checks show up regardless of whether the stock has increased or decreased in value for the year because they are funded by the underlying operating results of the company itself; the cash produced by collecting revenue from franchisees selling cheeseburgers, french fries, chocolate shakes, chicken nuggets, apple pies, breakfast sandwiches, and coffee.
Even when the company faces headwinds, the McDonald's business itself is successful enough that the dividend has grown substantially over the years, decades, and generations. It has been a major wealth building force for those who own part of the global empire and want to get rich. In fact, since McDonald's first paid a dividend all the way back in 1976, it has increased the payout each and every year, without exception, at aggregate rates that utterly dwarf inflation. The past 15 to 20 years demonstrate the pattern. Looking at the maximum timeframe we can find on a recent Value Line Investment Survey tear sheet, back in 1999, one share of McDonald's paid a dividend of $0.20. This year, as you already know, the dividend rate is $3.56. That is a 17.8x increase, or a 19.72% compound annual growth rate. You didn't have to do anything besides hang on to your stock and you were showered with more cash each year.
#3: Own a Business That Grows, Have It Reinvest the Profit for You, and Then Sell Your Stake at a Higher Price Than You Paid
When you buy an asset at one price and sell it at a higher price, the profit is called a capital gain. Business owners can often enjoy this outcome by taking profit generated from the company and reinvesting it into growth so future profits are higher. An illustration might help. Imagine that you owned a hotel and continually plowed your earnings back into building additional hotels. Twenty-five years pass. If you've managed your capital allocation wisely, and the businesses themselves are high-quality (you do a good job filling rooms, your staff knows how to go into the community and drum up business to get special event bookings, you are adept at selling enhanced services to get more out of each guest, etc.), you're probably going to receive a much higher price than the sum of the aggregate profits you've reinvested when you go to sell your stake. This happens because the equity you are selling has more value; more buildings, more revenue, and more profit. It's akin to baking a cake; the eggs, flour, sugar, oil, and other ingredients come together to form something much more impressive than the sum of the parts.
It is important that you understand capital gains and cash dividends are not mutually exclusive. In fact, they almost always go hand-in-hand once a company is well-established and profitable. Some of the most successful companies in history made their shareholders rich because they both grew in value and provided a stream of earnings paid out to the stockholders. For example, a $10,000 investment in Wal-Mart at the time of its IPO in the 1970's is worth more than $10,000,000 between reinvested cash dividends and growth in the value of the business as stores rolled out across America. A single share of The Coca-Cola Company bought for $40 at its initial public offering in 1919, with dividends reinvested, is now worth more than $15,000,000.
These companies retained a lot of their earnings and funded growth. That growth allowed the dividend rate to be increased each year, as well. When you look at both of these things together -- capital gains and dividend income -- it is called total return.
#4: Own Something of Value (Like Real Estate) and Rent It to Someone Who Needs or Desires It In Exchange for Cash
There is a big advantage to making money from this type of investment and it has to do with taxes. At the time this article was published in 2016, if you are an ordinary investor, you probably wouldn't have to pay the 15.3% self-employment taxes on your rental income that a small business owner would have to pay. This means passive income earned from this source might result in more cash staying in your pocket instead of going to the government. I once wrote about a man I know who has a net worth of several million dollars and pays very little taxes as a result of his investment strategies, part of which included buying institutional buildings and renting them. This can be an intelligent way to get rich, and a lot of people have done precisely that with property portfolios developed, acquired, accumulated, and nurtured over time.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.