The Greatest Trilogy

When I was a senior in high school, I got the opportunity to select from a wide range of electives for my final year. Some of the electives were hands on, like woodshop or cooking. Some were more academic, like creative writing or even astronomy. However, when I flipped through that catalogue, there was one elective I was zeroed in on – film studies. After all, I loved movies and what better way to intellectually study them than at 8:00 AM in a class full of VERY motivated seniors on the march to graduation.

I’ll be honest, I don’t remember much from that class. At that point in the year, I knew I was headed to the University of Wisconsin after graduation, and I was ready for the world awaiting me outside of the Chicago suburbs. However, what I do remember is something my teacher told the class when discussing film – great things come in threes. Think about some of the greatest trilogies – Lord of The Rings, The Godfather, and even the original Star Wars. Again, great things come in threes. Even a cinematic favorite of my sister and mine, Pitch Perfect, is a trilogy. The rule is almost too good.

When I started working in finance, I realized that the rule of threes didn’t go away. However rather than using the rule in the context of lightsabers or singing college girls, we use it in asset classes. More simply, in what the average investor (like you or me) can invest in.

While George Lucas has Star Wars, The Empire Strikes Back, and Return of the Jedi, investing has its own big three. equities, fixed-income, and real estate. When people talk about “investments” they are usually talking about one of these three. You may have heard of one or all of these, but at a high-level, what are they? Let’s explain them with an example all of us know – a lemonade stand.

Lemonade Investments

When the summer would hit my neighborhood in the late 2000s, the most saturated market in the state would flip from financial firms to lemonade stands. In fact, if I was smart, I would’ve spent less time playing Madden 2009 on the Wii and gotten a stake in those stands. I swear some of these neighborhood kids would be earning double what they would make in allowance in a week just because their parents got them a table, some cardboard, lemonade powder, and water.

Regardless, hindsight is 20/20, but what if we went back and helped my childhood self make a smarter decision of how to spend his summer. So, let’s put that Wii-mote down and get to work.

There was one stand right near the entrance to my neighborhood. Cars would be tasked with the tough decision of ignoring a bunch of smiling elementary school kids and driving by (heartless) or stopping for a few seconds and paying the $0.50 for some lemonade. In fact, the operation was so sophisticated they would bring the cup of lemonade right to your window.

But the three kids who went in on the stand together quickly realized that they had bitten off more than they could chew. The stand was too small and crowded to produce enough lemonade to meet demand. Cars would wait in a line, then drive away realizing they were wasting time waiting to pay for the right for an eight-year-old to poorly make them some lemon-flavored water.

It was clear they needed more room. But how would they do it? Well, I had $100 of Christmas money to deploy and willing recipients. It was only June. The summer was young. But the question remained - what type of deal would I offer them?

Fixed-Income

A fixed-income deal is the least risky of the bunch and possibly the most straightforward. With this investment type I offer the business a clear value proposition. I will give them $100 to upgrade the stand if they pay me back in two months.

However, this comes with a caveat. I must pull that $100 out of my piggy bank and part with it. I need to get some reward for the fact I have to wait two months to get paid back. In addition, if the stand struggles to sell lemonade, I may not get my $100 back quickly. I would have to get my parents to go to their parents and ask for it back – what a hassle. To compensate for these two factors (time and risk) I require they pay me $2 each month so I get some compensation. In addition, I demand repayment before anyone else who gives them  money. It is important to note that this is an investment for myself, and debt for the stand.

In short:

Lemonade Stand: Gets $100 Today

Me: Gets $2 in July, $2 in August, $100 in August (Repayment)

I get $104 in return for lending out $100. I made a $4 profit on $100 which is a 4% return. ($4/$100). As I initially mentioned, you can see that the payments here are fixed. I get $4 each month and $100 back regardless of what happens in the business. I also get priority claim, meaning I am paid before everyone else. This is why fixed income is perceived as the safest investment type of the three. As long as the stand makes at least $104 for the entire summer, I will get paid back.

Fixed-income borrowers can range from corporations all the way to governments. The largest fixed-income market in the world is for US Treasury Bonds. These are fixed-income investments issued by the US Government. They are perceived as “risk free” by markets because the US Government can print money to pay for these obligations, so default is seen as a slim possibility.

 However, what if that stand makes $375 for the whole summer. Well, I still get paid back $104. It is key to note that fixed-income is contractual. I get exactly what the borrower and myself agreed upon. If I’m optimistic about how much the stand could make in sales, I may take a different approach.

Equity

In this approach, I go to the stand and still give them $100 up front. However, I take an ownership stake instead. How is this different from fixed income? The key is ownership. In fixed income I have contractual obligation to get paid back as a lender. In equity, I own part of the business and share in the profits – and the kicker – share in the LOSSES. If the stand doesn’t make a profit, I have to go home without my Christmas money and my head hung low.

Let’s put some substance to this. Let’s say the three kids have already sunk $200 into this stand. When I come with my $100, the business now has cash value of $300. This includes my $100 plus the original $200. Since I pitched in 1/3 of the capital, it is only fair for me to get 1/3 of the profits. If the stand makes $375 in profits, I would get $125 at the end of the summer ($375 * 1/3).

In short:

Lemonade Stand: Gets $100 Today

Me: Gets $125 payout (1/3 share of profits) in August

After subtracting my initial $100 of Christmas money I invested up front, I get a $25 return on $100 of initial capital. That is 25%! That blows the 4% fixed income return out of the water! Why is that? This all relates to risk and return. First, there is no guarantee that the stand will make $375 in profits. It could make less profit or it could lose money. In addition, if anyone got to the stand before I could tie my shoes and get outside and offered the stand a fixed-income deal, they would get paid back before me.

Since debt has priority to equity, I must subtract debt cash flows before even sniffing a payout in ownership. If the stand also owed Simon from down the block $50 for some lemons they purchased, the cash that would be shared would be $325 ($375-$50) meaning I would get $108. That is marginally better than my $104 payment under the debt example. Is that additional $4 worth the risk I lose all my money?

As a result, you will see higher returns on stocks than fixed-income. Individuals can invest in individual companies or baskets of companies called ETFs and Index Funds. However, these carry more risk, and short-term (and sometimes long-term) could lose initial investment value.

Real Estate

Let’s get crazy for this last one. Instead of approaching the lemonade stand with cash to buy a bigger stand expansion, why not buy the expansion and rent it to them?

In this situation I would argue that I have an optimistic outlook for stands in the neighborhood. For example, if this specific lemonade stand stops selling lemonade, I could rent the expansion to another stand for the season. Even beyond August, I could rent the stand to the kids selling water in September - November for all the runners in the subdivision. Then in November - February I could rent to the kids selling hot chocolate. I am optimistic that there is always some type of stand selling some product throughout the year.

I don’t have an ownership stake in the business, but instead in the stand itself. In this specific type of investment, I would charge them $25 per month to use the stand. From the kids' perspective they pay $75 for the summer when it would have cost them $100 to buy it outright. An additional benefit for the stand is that they can give the expansion back at the end of the season. They don't need to store it in their dad's garage or go through the hassle of trying to sell or rent it to someone else. They are free and clear after their rental period is done.

This may cause you to pause here. Wait - I spent $100 on this expansion and only get $75 back. This is a losing investment!! However, that does not account for the fact I will continue to rent this out to the water salemen in the fall and the hot chocolate salesemen in the winter. This is 9 total months of collecting $25 per month. That is $225! While it is a longer period that I will take to recognize this, it hinges on three assumptions.

The first is that I can rent this out out reliably for 9 months and there will be no period where the stand is sitting unused in my garage because no one wanted to rent it. The second is that I can reliably collect $25 per month. If five other kids with the same idea as me start renting expansions, I may have to drop my price to $20 to compete, can I survive if price gets pushed? The last is the expansion will last 9 months. If I charge $25 for rent but my expansion breaks after 3 months, I have lost money.

These are the considerations of investing in real estate. It is a longer payback, but it has more reliable cash flows and exposes investors to the general market for real estate, not one specific company or industry in most cases.

In short:

Lemonade Stand: Gets to use expansion (3 month term)

Me: Gets $25 per month in rent (3 month term)

Real Estate investments can be bought through Real Estate Investment Trusts (REITs). Equity REITS purchase and hold property while passing rent payments through to investors.

Decision

You may now wonder – well, which one is best? Just like all other investment decisions, it depends on what you feel about the market, and what your individual risk tolerance is.

Do you want a low-risk option that protects your money but gets reasonable return? Then fixed income may be the route.

Or are you optimistic about the business and want to share in the profits? Then equity is the pick.

Or are you in it for the longer-term? You like the trend of stands in the neighborhood and want to capture on that trend with reliable cash payments (even if payback is longer)

We’ll dive into specifics with each investment down the road, but this big three is important to understand. They are the core of retail finance (otherwise known as finance that average househoulds engage within). And although knowing this trilogy won't give you any cool quotes or songs to add to your Spotify playlist, it serves as the basis of something even cooler than a cinematic universe - your very own financial universe.