On Capital & The Key Five

When I was in school, they taught me that capital was how a firm chooses to finance itself – two main choices debt or equity.  We learned a lot of different models and theories about the nature of markets and the choices that firms make with regard to their capitalization.  I graduated in 1990; spent a decade in Private Equity; and a further decade in Real Estate investing. The real world is far less tidy than what your finance professor would have you believe.
What about us?  What are the key aspects of capital as they relate to regular folks.  I’m going to outline those and get into more detail in future articles.  I’m going to use my own terminology – like athletics, there is a fair amount of overlap and words used to define different things.  Over time, I’m sure we’ll develop a common language like we did at Endurance Corner.

What is it?
Free Capital is money that you have readily available to make investments — it is available quickly for investment.  What is an investment deserves a separate article – so I’ll save that for later.

Net Worth
Simply put your net worth is your assets less your liabilities.  Because assets are more visible than liabilities, we often make the mistake of assuming people with lots of assets have lots of net worth.  In a crisis, free capital is much more valuable than net worth (also called equity).

Acquiring Capital
You can be the best investor in the world but, if you don’t have any capital to invest… well, you won’t be particularly successful.  So, to create financial stability, the first habit you need is the ability to acquire capital.  The answer is simple, but not easy: always spend less than you earn.

The only time you want to vary that rule is when you make an investment.  

The Key Five on Investments:

  1. Limited in number across our lifetime
  2. Generate a net positive annual return
  3. Preserve capital
  4. Have an ability to sell in all market conditions
  5. Make a positive impact on our life situation

This is the first place where the reality of personal investing differs from human nature and the media.  People will try to convince you that the Key Five don’t apply.  When you hear someone talking like that look for where they make their money.

Ultimately, acquiring capital has to do with not losing capital… the Key Five are essential to remember.  The discipline they impose will rule out many schemes that can get you into trouble.

Some common schemes:

  • Second home – typically cash flow negative annually – therefore a luxury good, not an investment.
  • Cars, bikes, motorized anything – high cost of ownership, depreciating asset – treat as expenses.
  • Gold, commodities – realize that you’re gambling and any positive return is due to chance.
  • Stocks & Bonds – I lack the knowledge and confidence to make a bet large enough to have a material impact on my life.  
Many opportunities fall into the category of tinkering, they won’t make a difference in my life so fail Rule #5 and I don’t materially commit my capital.
To avoid gambling, I need to be honest with myself about what I don’t know as well as my ability to rely on historical information.