Personal finance can be summed up in less than 10 words:
Spend less than you earn and invest the difference.
Keeping your expenses lower than your income provides a margin of safety, but it also generates a surplus that you can invest. This is crucial, because investing is the secret sauce that allows your money to make money on your behalf. It’s the biggest key to building wealth and finding freedom.
Investing is one of those things that everyone knows they should be doing, but too many people hesitate. They aren’t sure how to get started. They’re afraid of making a mistake. They don’t understand the basics.
While investing is the most complicated pillar of personal finance we’ve yet encountered, this post will try to make the core ideas simple enough that you can understand what you need to develop a solid strategy.
Investing is the ultimate way to multiply your wealth.
It’s not dependent on you working smart or working hard. Your money just works on your behalf making money for you.
Investing is a great way to pursue one of the ultimate goals of personal finance: Your freedom. When your investments grow large enough, you can free yourself from the need to earn an income at all.
One rule of thumb is known as the 4% rule. The rule suggests that if you can build a nest egg large enough that it is 25x your annual spending (in other words, your annual spending is 4% of your portfolio), you can live off withdrawals from your investments with little chance of your portfolio failing.
If you want to become truly financially independent, investing is the key.
Investing in What?
There are a lot of things you could invest in, such as:
- Real estate
- Starting a business
- Your own education
- Physical assets like gold
- Digital currencies like bitcoin or etherium
All of these can be good options. Historically many people have become wealthy through real estate or starting their own business. More recently many have struck it rich investing in digital currencies.
Of course, all these options have their downsides as investment options:
Real estate, starting a business, and investing in your own education require not only financial investments, but also significant investments of time and energy. That doesn’t mean they aren’t worth it, but it does mean you might need to look elsewhere if you are only planning on bringing money to the table.
Digital assets like Bitcoin can make money, but they are speculative in nature. That just means that, like baseball cards or beanie babies, you’re hoping the next person will be willing to pay more than you did. You could make a lot of money or lose your shirt. It’s unclear which is more likely.
The Best Bet For Most People
Take a look at this chart:
This is the Dow Jones Industrial Average. It’s an average of 30 large companies traded on American stock exchanges. It is one of our most venerable stock market indexes. This chart shows its growth from 1896 to 2011.
Notice a few things about this graph:
- The scale on the Y-axis isn’t linear, it’s logarithmic
- If the Y-axis were on a linear scale, the Great Depression would be a tiny blip
- Because of the scale, the 2008 crash looks much less severe than it really was
- This chart doesn’t show the 2010’s, which were a decade of enormous growth
- As I’m writing this, the Dow is at an astonishing $33,677.27
- It’s a bumpy ride on any scale, but the market goes UP over time.
That last point is crucial, so it’s worth spending a moment thinking about it.
Why Does The Market Go Up Over Time?
The question behind the question is really: Why should we believe that the stock market will continue to go up in the future?
To answer, we need to think about why the market goes up and down at all.
Let’s start by defining what we mean by a stock and what me mean by a market.
What is a stock?
A stock is simply a share of ownership of a business. If you own a share of Apple stock (AAPL), you own a tiny slice of the technology company Apple Inc.
Why might you want to own a piece of a company? First of all, the company might pay you a dividend, a share of their profits. Second, the company might grow in value leading your share to become worth more than you paid for it.
What is a market?
A market is just a place (literal or figurative) where people come together to buy and sell things. We can think of “the stock market” as a collection of stock exchanges such as the New York Stock Exchange and the Nasdaq. When you buy Apple stock, you don’t buy it from Apple, a broker buys it for you from a previous owner through one of these exchanges.
This means how much someone is willing to pay at a given moment drives the price of stocks. Does this mean that the stock market is really just another form of speculation? Well, in the short term, yes. Much of the day-to-day fluctuation in stock prices is due to day traders trying to make a quick buck.
But over the long term, it’s hard for even the most deranged speculator to deny such objective facts as that Apple is a much more valuable company than it was at the time of its IPO in 1980.
But we still haven’t answered the question: Why do we expect the market to keep going up?
The Fundamental Asymmetry of Business
The short answer to why the stock market goes up over time is that capitalism works.
The more detailed answer is that there is an asymmetry in business that is hidden in plain sight. A company that goes under can only lose 100% of its value, but there’s virtually no limit to the amount it can grow.
Can a stock grow 100%? Absolutely! How about 200%, 500%, 1,000% or even 10,000%? They can and they do.
When you give people the ability to interact in a free market, some firms will rise to the top and perform exceptionally well. Some will do good enough to stay in business. Some will lose everything. But the winners win big and the whole market gets a boost.
How Do I Invest?
We just covered the fact that just a few of the companies account for a large portion of the market’s upside. So how do you identify these companies?
I don’t know.
If I did, I would be very rich.
But instead of picking the right stocks, you could just buy a whole bunch of them and improve your odds that way.
Wait a minute, you might be thinking, what’s he playing at? I don’t have the money to invest in a bunch of different companies. Much less the time to research them all!
Don’t worry. I was just leaving you hanging for dramatic effect. There are some simple tools that can help us invest passively and put our wealth generation on autopilot.
You see, mutual funds are the magic potion of investing…
Just kidding. The picture of the cauldron is there to illustrate a non-magical benefit of mutual funds. Instead of needing to wait until you’ve saved up a bunch of money to start investing, imagine you pooled your money with other investors in one big pot (or cauldron).
This is essentially what a mutual fund does. Investors like you put money into the fund, the fund manager uses these resources to buy securities such as stocks, and the investors own shares of the fund instead of owning the shares of stock directly.
Traditional, actively managed mutual funds have two main weaknesses:
We’ve seen that the market as a whole tends to go up over time, but what if our fund manager is terrible at picking stocks and we lose money?
Or maybe he’s okay at picking stocks, but our returns don’t keep up with the market.
Of course, there’s a chance that he can actually beat the market, which leads our greedy side scheming about how we can turbocharge our savings by picking the right mutual fund.
There’s just two problems:
- It’s so rare to beat the market over time, that there’s a serious debate about whether it’s just luck
- We don’t know who the superstar fund managers are going to be any more than we know what the superstar stocks are going to be
There’s no such thing as a free lunch, and having someone buy and sell stocks on our behalf isn’t cheap. This is both because the guy needs to get paid, and because all his buying and selling incurs heavy transaction fees that either drag down the performance of the fund or are indirectly passed along to us in the form of higher fees.
Here’s the bottom line when it comes to fees: they matter more than you think they do.
The main fee you pay when investing in a mutual fund is the fund’s expense ratio. This is a percentage of your portfolio that is silently taken away in the background every year without you even noticing. The number doesn’t sound like anything significant. Maybe it’s 1%. Maybe it’s 0.5%. But it is definitely significant.
To illustrate, let’s look at what would happen if you invested $10,000 for 40 years at a 5% rate of return and paid no fees:
Wow, you started with $10,000 and ended up with $70,400. Congratulations my friend, you are one savvy investor.
Now let’s look at what would have happened if you had been paying an expense ratio of just 0.5%:
Ouch! You should have ended up with $70,400, instead you have $57,610. What happened to the other $12,790? It was silently eaten away by fees.
Wait a second, you might be thinking, $12,790 is more than 18% of $70,400 and more than 22% of $57,610, how is this possible with an expense ratio of just 0.5%?
Your shock and outrage is justified. There are three things that happened here:
- Your broker collected the expense ratio every year as your money was growing
- The shortfall comes not just from the fee itself, but the compounding you missed out on
- As your portfolio grew, the fee grew with it
The worst part is that great returns are never guaranteed, but costs are. You pay them both when you make money and when you lose money
Related Post: The Tyranny of Compounding Costs
The solution to both problems of most mutual funds (risk and cost) can be found in a special kind of mutual fund:
An index fund is really just a special type of mutual fund. Instead of a fund manager buying and selling stocks based on how he thinks they will perform, the fund seeks to replicate the composition of a stock market index like the S&P 500.
Here are a few notable stock market indexes:
The Dow Jones Industrial Average
The Dow tracks the performance of just 30 commonly traded companies. It was created in the late 1800’s, and was limited by the (lack of) technology of the era. Because it tracks so few stocks, it’s a pretty low resolution picture of the market as a whole.
Of course, because it dates back so far, it is the ideal index to look at when evaluating the performance of the market of as long a time period as possible.
The S&P 500
The S&P is an index that tracks 500 of the largest publicly traded companies in America. It sort of represents the Pareto (80/20) approach to tracking the market. The 500 companies that make up the index are less than 20% of all publicly traded companies, but they usually account for almost 80% of the value of the stock market.
It has been around since the 1950’s. Here is what its performance has looked like:
This chart only goes up to 2016, but at the time I was writing this post, the S&P 500 was valued at $4,133.55.
The Russell 3000
The Russell 3000 and indexes like it are sometimes called Total Stock Market Indexes. As the name suggests, the provide the highest resolution image of the market as a whole. For instance, the Russell 3000 tracks 3,000 different stocks, which is roughly 98% of all publicly traded stocks.
Index vs Index Fund
Technically the index itself if different than an index fund. For instance, you can’t invest directly in the S&P 500, but you can invest in VFIAX, and index fund from a company called Vanguard that tries to replicate the S&P index.
You could go for a a fund that tracks the whole market instead and invest in VTSAX, Vanguard’s Total Stock Market Index Fund.
Whether you invest in an S&P 500 or a Total Market Index Fund is up to you. I like investing in the total market, but like everyone else I have no way of knowing which will do better in the future (and chances are they will perform in a similar fashion anyway).
Advantages of Index Funds
- They provide instant diversification across companies and industries
- Because of lower asset turnover, they are more tax-efficient than many alternatives
- A guaranteed a market rate of return (minus fees and taxes if applicable)
- They let you invest at extremely low cost
As we saw earlier, that last point is incredibly important because fees can take a giant bite out of your returns.
If you recall, we demonstrated that $10,000 invested at 5% grows to $70,400 over 40 years. But if you have a 0.5% expense ratio, you’ll only be left with $57,610. Fees will silently erode $12,790 of your earnings.
Well, here is a chart that shows what happens with an expense ratio of 0.04%:
In this scenario, you keep $69,282 and lose out on just $1,118 due to fees.
Here are a few examples of actual total stock market index funds with expense ratios of 0.04% or below:
- VTSAX — Vanguard Total Stock Market Index Fund
- FZROX — Fidelity ZERO Total Market Index Fund
- SWTSX — Schwab Total Stock Market Index Fund
It’s important to remember that while the expense ratio is the most common fee with index funds, it may not be the only one. You’ll have to read your fund’s prospectus to spot any hidden fees.
Related Post: FZROX vs FTSAX: Which is the Best Low-Cost Index Fund?
In order to get started, you’ll need to open an investment account. Let’s look at some of the options available.
At a high level, there are two types of accounts:
- Retirement accounts (401k’s, IRA’s, etc)
- Regular brokerage accounts
The major difference is the level of protection from taxation. Retirement accounts let your money grow tax-free as you save for retirement. They can also protect your money from taxes either when you put it in or when you take it out:
- Traditional retirement accounts are tax-deferred, meaning they save you money on taxes the year you put your money into they account
- Roth retirement accounts let you take out your contributions tax-free. So you save nothing on taxes this year, but you’ll save later.
Let’s take a more detailed look at the two main kinds of retirement accounts (both of which come in both Traditional and Roth flavors)
A 401(k) is an employer sponsored retirement account. Your employer deducts money from your paycheck, put into the account and you can pick between a limited number of investment options your employer has made available.
401(k)’s have two big advantages:
- They help you save on taxes
- Your employer will often match your contributions up to a point
- An annual contribution limit imposed by the government
- You are forced to choose between a limited number of investment options, which might all be bad
IRA stands for “Individual Retirement Arrangement” and you open one with a broker like Fidelity or Vanguard. Like a 401(k), it can save you money on taxes, it has a contribution limit, and it comes in both traditional and Roth flavors.
If you hit the contribution limits on your retirement accounts you can open a regular brokerage account to keep investing without limits.
If you have a traditional job, it makes a lot of sense to start by investing in your 401(k). If they are offering to match a portion of your savings, you don’t want to miss out on free money!
You can also start by opening an IRA (Roth or traditional) and setting up recurring deposits and investments (make sure you set up both. I talked to a friend the other day who had money sitting in his Roth IRA but not invested in anything).
Remember that fees are important. You want to look for investment options that aren’t weighed down with unnecessary fees. You also want to look for expense ratios below 0.05% or so.
It can be helpful to sign up for a free service like Personal Capital that will track all your investment options (as well as the rest of your finances) in one place.
You might be thinking is that really all I need?
It’s probably all you need to get started. There are still some important concepts to cover. The most significant of which is how to use asset allocation to protect you from the volatility of the stock market.
But this post is long enough and those topics become more significant later. In the beginning of your investment journey, you don’t have much capital exposed to risk and you’re making regular contributions to smooth the ride.
Once you have some serious skin in the game, you’ll need to master investing 201. But until you’re up and running, the most important thing is to understand the market just well enough to get comfortable investing.