The 2 Approaches to Building Wealth: Start a Business or Buy Businesses

In striving for financial independence, a comfortable retirement, or any other worthy financial goal, only two methods exist to reliably generate needed wealth.  Sure, one could win the lottery, but not reliably.  The only two ways to build long-term wealth are 1: Owning a successful business or 2: Owning small portions of a large group of successful businesses.  #1 can create incredible wealth, but the risks are high and the odds of success lower.  #2 is synonymous with common stock investing.  While it won’t likely create as much wealth as starting a successful business, a lifetime of steady stock ownership has, historically, generated significant returns well above the remaining alternatives.

On the spectrum of risk vs. reward, the highest return and wealth creating potential is starting a business.  Starting a business often entails high risk, justifying the rewards.  Let’s look at a few of the risks.  The stereotypical business owner put all or a majority of his or her savings toward starting the business.  Depending on the type of venture, that owner likely borrowed funds from a bank or Small Business Association.  In a new business, even using an LLC or corporation, the owner likely signed a lien on his or her personal assets.  Furthermore, in starting the business, the owner often leaves a previous career, giving up the income.

While quoted small business failure rates are quite variable, using data from this Business Insider Article suggests that 20% of small businesses fail in their first year and half of them fail in the first five years.  The causes of failure are varied, but often the failure of a small business results in significant or total loss of wealth for an individual.

On the flipside, successful entrepreneurs can create massive wealth for themselves and generations of their family.  Sure, the Gates, the Zuckerbergs, and the Buffetts exist.  But for each one of them, there are many more restaurant owners, gas stations owners, residential housing contractors, and landlords running their own businesses and meeting the needs of their customers.  They don’t show up on CNBC or 60 Minutes but are successful nonetheless.  Instead, many of these people live an average lifestyle, investing business earnings back into their business or providing for their family.  For an in-depth look at the demographics of the typical millionaire, most of whom are business owners, I strongly recommend reading The Millionaire Next Door.  The data is somewhat older but relevant.

Not everyone is cut out to start and operate a business, though.  A myriad of barriers prevents the average person from doing so.  Some individuals might prefer the corporate route with its relative security and benefits or they simply aren’t risk takers.  Others might not have sufficient savings to start the business they want.  Finally, many people don’t have the financial assets which allow them to go without income.  A combination of debt payments and ongoing family obligations limit one’s options.

For individuals and families who are unwilling or unable to start a business, the next best option is common stock investing.  I imagine that my assertion will cause immediate objections: “Real estate is better!” or something like that.  However, I believe that owning residential or commercial property to flip or rent is a business and falls into the “start a small business” category discussed above.  With national real estate prices historically trending with inflation, genuinely passive direct investments in real estate will, on average, merely earn the property managers, contractors, and real estate agents a bunch of money while the owner shoulders all the risk with little gain.  Instead, operating real estate investments like an actual business, with as much horizontal and vertical integration as possible is a must for any significant success.

Now that the previous objection is out of the way let’s get back to common stocks.  For a detailed primer on the subject, I suggest Stocks for the Long Run by Jeremy Siegel (the 2014 edition).  While it only contains data through the end of 2012, common stock returns have been outstanding since then.  The book provides analyses and comparison of different investment asset classes from 1802 (also the founding year of my Alma Mater, in case you were wondering).

Why common stocks? When many people think of stock investing, they really think of stock trading.  Buy one day, sell the next, hope they make some money.  This belief results in equivocating that investing and Wall Street are akin to going to a casino or betting on how many 3-pointers Lebron James will make in the 4th quarter.  I’m not writing about gambling; I’m writing about investing.  A common stock investor has the opportunity to buy a small portion of profitable companies in all sorts of industries.  Today, an investor can buy into a diversified stock portfolio at the click of a button, with investments in companies large and small, in every industry, and around the world.

Of course, owning many stocks reduces the risk of permanent loss to incredibly low levels.  With that tradeoff, though, potential returns are lower than starting and operating a small business.  U.S. stocks have averaged a real return (after accounting for inflation) of about 6.6% per year since 1802.  Even with the Great Depression, the Great Recession, and dozens of other financial panics, stock returns have been consistent for holding periods of 20 or more years.

Some periods are better than others concerning stock returns but owning a broad set of businesses is the best option out there.  Putting cash into certificates of deposit won’t generate long-term wealth, nor will treasury bills, notes, bonds, or gold.  In fact, a CD or savings account is more likely to have a negative return after inflation.  That is, after a year in a CD, that dollar will buy less than when the CD was purchased.

To put things in perspective, the average annual real return on treasury bonds from 1802-2012 was 3.6%, just over half of the 6.6% returns from U.S. stocks.  That 3% is a massive difference when looking at compounded returns.  A dollar invested in bonds in 1802 was worth $1,778 in 2012, while the same dollar in stocks was worth $704,000 in 2012, a difference of almost 400 times.

Without a doubt, outside of operating a successful business, the best option to create long-term wealth and achieve long-term financial goals is common stock investing.

 

Are you interested in learning more about financial planning and investing?  Please visit my website to learn about how I help our service members and veterans plan for and achieve financial independence.  You can also contact me at Derek.Merkler@Parsonex.com.

My blog discusses a myriad of financial topics and challenges, book reviews, and commentary on current events in the financial world to benefit our military and veteran community.  I attempt to be as thorough as possible when examining each subject but can never account for every possible scenario.  Please remember to consult with your own advisers for advice on your particular situation.  Thank you for reading!

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