of more than $10 million and can retire if he wants. Even more important to many business owners — and the reason that financially successful entrepreneurs such as Calvin don’t call it quits after they’ve amassed a lot of cash — are the nonfinancial rewards of investing, including the challenge and fulfillment of operating a successful business.
Similarly, Sandra has worked on her own as an interior designer for more than two decades. She previously worked in fashion as a model, and then she worked as a retail store manager. Her first taste of interior design was redesigning rooms at a condominium project. “I knew when I did that first building and turned it into something wonderful and profitable that I loved doing this kind of work,” says Sandra. Today, Sandra’s firm specializes in the restoration of landmark hotels, and her work has been written up in numerous magazines. “The money is not of primary importance to me,” she says. “My work is driven by a passion … but obviously it has to be profitable.” Sandra has also experienced the fun and enjoyment of designing hotels in many parts of the United States and overseas.
Most small-business owners (myself included) know that the entrepreneurial life isn’t a smooth walk through the rose garden — it has its share of thorns. Emotionally and financially, entrepreneurship is sometimes a roller coaster. In addition to receiving financial rewards, however, small-business owners can enjoy seeing the impact of their work and knowing that it makes a difference. Combined, Calvin’s and Sandra’s firms created dozens of new jobs.
Generating Income from Lending Investments
Besides ownership investments (which I discuss in the earlier section “Building Wealth with Ownership Investments”), the other major types of investments include those in which you lend your money. Suppose that, like most people, you keep some money in a bank, either locally or online — most likely in a checking account but perhaps also in a savings account or certificate of deposit (CD). No matter what type of bank account you place your money in, you’re lending your money to the bank.
As I discuss in more detail in Chapter 7, you can also invest your money in bonds, another type of lending investment. When you purchase a bond that’s been issued by the government or a company, you agree to lend your money for a predetermined period of time and receive a particular rate of interest. A bond may pay you 4 percent interest over the next ten years, for example.
An investor’s return from lending investments is typically limited to the original investment plus interest payments. If you lend your money to Netflix through one of its bonds that matures in, say, ten years, and Netflix triples in size over the next decade, you won’t share in its growth. Netflix’s stockholders and employees reap the rewards of the company’s success, but as a bondholder, you don’t; you simply get interest and the face value of the bond back at maturity.
THE DOUBLE WHAMMY OF INFLATION AND TAXES
Bank accounts and bonds that pay a decent return are reassuring to many investors. Earning a small amount of interest sure beats losing some or all of your money in a risky investment.
The problem is that money in a savings account, for example, that pays 1.5 percent isn’t actually yielding you 1.5 percent. It’s not that the bank is lying; it’s just that your investment bucket contains some not-so-obvious holes.
The first hole is taxes. When you earn interest, you must pay taxes on it (unless you invest the money in municipal bonds that are federal and state tax-free or in a retirement account, in which case you generally pay the taxes later when you withdraw the money). If you’re a moderate-income earner, you may end up losing about a third of your interest to taxes. Your 1.5 percent return is now down to 1 percent.
But the second hole in your investment bucket can be even bigger than taxes: inflation. Although a few products become cheaper over time (computers, for example), most goods and services increase in price. Inflation in the United States has been running about 2 percent per year over recent years (3 percent over the much longer term. Inflation depresses the purchasing power of your investments’ returns. If you subtract the 2 percent “cost” of inflation from the remaining 1 percent after payment of taxes, I’m sorry to say that you’ve lost 1 percent on your investment.
To recap: For every dollar you invested in the bank a year ago, despite the fact that the bank paid you your 1.5 pennies of interest, you’re left with only 99 cents in real purchasing power for every dollar you had a year ago. In other words, thanks to the inflation and tax holes in your investment bucket, you can buy less with your money now than you could have a year ago, even though you’ve invested your money for a year.
Considering Cash Equivalents
Cash equivalents are any investments that you can quickly convert to cash without cost to you. With most bank checking accounts, for example, you can conduct online transactions to pay bills or do the old-fashioned writing of a check or withdraw cash through an ATM machine or from retailers like a grocery store that enable you to get cash back when making a purchase.
Money market mutual funds are another type of cash equivalent. Investors, both large and small, invest hundreds of billions of dollars in money market mutual funds because the best money market funds historically have produced higher yields than bank savings accounts. (Some online banks offer higher yields, but you must be careful to understand ancillary service fees that can wipe away any yield advantage — see Chapter 7 for information.) The yield advantage of a money market fund over a savings account almost always widens when interest rates increase because banks move to raise savings account rates about as fast as molasses on a cold winter day.
Why shouldn’t you take advantage of a higher yield? Many bank savers sacrifice this yield because they think that money market funds are risky — but they’re not. Money market mutual funds generally invest in safe things such as short-term bank certificates of deposit, U.S. government-issued Treasury
