You use both investments and contracts to build your net worth and reach your R Minus 10 milestone. What’s the difference between investments and contracts, and why does it matter? Because like any smart consumer, you need to know what you’re buying.
How To Spot an Investment
Most financial sites like this spend most of their time talking about investments. Sometimes it can seem like investments are the only way to build wealth. So much so, that most financial porn deals with investments.
Characteristics of an investment include the following:
- They are easy to buy, at least once your account is set up.
- You have no guarantee about what will happen in the future.
- A higher level of risk usually means a higher potential for reward.
- Often, you have the opportunity for compound growth.
- If you lose a lot of money, that’s probably on you.
Examples of investments include stocks, stock mutual funds, bond funds, index funds, exchange-traded funds (ETF), and real estate investment funds (REIT).
How to Spot a Contract
Contracts also help you build financial independence. You need to understand them as well.
Characteristics of a contract include the following:
- It is hard to buy, with a lot of paperwork that you actually have to read and sign.
- You have a guarantee about what is going to happen and when.
- A lower level of risk usually means a lower level of reward, as well.
- Sometimes, a contract offers the opportunity for compound growth.
- If you lose a lot of money, there’s possibly legal recourse for you. Contracts are enforceable in court.
Examples of financial contracts include the following:
- Insurance is a contract to pay you money should certain events happen or conditions are met.
- Social Security and pensions are contracts to pay you defined payments in the future.
- Mortgages and other loans are contracts that help you purchase and build equity in large assets over time.
- Bonds are contracts where you loan your money to a company or government agency. They agree to pay you back according to the terms of the bond.
What About My House?
Buying a house is making an investment in real estate. The value could go up; it could go down. There’s no guarantee on the direction of your home’s value. For most people, over time, they’ll build equity in their real estate.
The mortgage is the contract that you use to buy that investment. It’s definitely a contract. Have you seen all that paperwork? All the effort that people go through to buy a house?
When you sign your house papers, you receive a schedule of exactly how every monthly payment you make will be apportioned between interest, principle, and other fees. You know precisely what will happen with your mortgage.
When To Use Investments Versus Contracts
In the end, the decision between investments and contracts comes down to risk and compounding.
Risk is powerful and something you want to control as much as possible. Most of the paperwork that comes with a contract defines the risks for you and the other party to the contract.
On the other hand, if you’re willing and able to accept more risk, the power of compounding is often your reward.
When you need to clearly define and limit risk, choose a contract over an investment. What does this mean? Here are a couple of examples.
- If you want to grow wealth through real estate but define the amount of risk you’re taking, buy a mortgage contract. If you want compounding in real estate, consider buying shares in REITs.
- If you want to grow wealth through loaning your money but define the amount of risk you’re taking, buy individual bonds. If you want compounding in loaning your money, buy shares in bond funds and reinvest the dividends.
- Finally, if you want to protect your assets through low-cost life insurance and forgo compounding, buy term life insurance. If you want asset protection plus compounding, buy whole or universal life insurance that pays interest and builds equity. (All life insurance is based on contracts, but you see my point about balancing risk and compounding).
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