If you’re reading this, then you most likely don’t need to worry about getting eaten by some large animal tonight.
Which is great! Good work. Quick pat on the back. Maybe a compliment in the mirror.
To a degree, everything on the “base” of Maslow’s hierarchy of needs is covered in our society. We can get water from the faucet. We have shelter. We have access to food (or, imitation food if you’re still in college). But that could all go away.
Run out of money, and even in this highly futuristic world you’ll still be somewhat S.O.L (I’m not a socialist, but I have to admit, that’s kind of weird).
And the fear of ending up in this state: poor, destitute, and out on the streets with a -246 credit rating, is how so many people end up in jobs they hate.
Which brings us to the philosophy of this article:
How do you create a financial situation such that you’re not afraid of going a couple of months without a job?
Or one where you’re not worried about hitting a state past your 70s where you can’t work anymore, and need to live off of your savings and investments?
This is how.
Let Me Show You a Magic Trick
We’re going to compare two people.
Nick is a smart, savvy, investor, representing you after reading this article.
He’s 25 and he realizes he should start investing. So he puts the greatest amount into his IRA (we’ll get there, don’t worry) for the next ten years, then says “eh that’s good enough” and stops.
His total contribution: 55,000
But when he turns 75 (we’re retiring later than our parents, accept it now) and starts drawing down his IRA, it has $1,229,000 in it. Not bad.
Now let’s look at another friend, Nat (I have to use my name for the silly people, only fair).
He’s 35, and has just realized now that he should start investing. So he puts 5,500 in every year until he’s 75.
His total contribution: 225,500
The amount in his account when he’s 75? $1,186,000. Just shy of Nick’s, but he contributed almost 5x as much!
This is the power of starting to invest early and taking advantage of compound interest. Essentially, compound interest means that as your amount of money increases, the percentage you return on that amount increases as well.
So if you have $100 and get a 10% interest rate for 5 years, here’s what it will look like:
As you can see it’s not just going up by $10, it’s going up by 10% of the amount in the account each year. So an extra 10 years (by starting at 25 instead of 35) adds a LOT of years of compound interest.
For the math geeks, that’s the same as multiplying it by (1* 1.1^10) or 2.59.
That’s why I say this is an easy way to earn 2 million. If you invest your IRA max each year from 25 till 75, at a 7% return rate, you’ll have about $2,235,909. You can check my math here.
And making it happen is surprisingly easy if you have the discipline to set the money aside. Just read on.
Paying debt vs. investing?
One thing before we move on to tactics. Let’s talk about debt.
It’s (almost) always better to pay off your debt before you start investing. This is 100% true with credit card debt, and it’s mostly true with student loan debt.
The exception is when the APR on the debt is lower than what you could reasonably expect in the market.
For example, an APR of 4% might be worth keeping because paying that off quickly loses you the opportunity to invest with an average 7% return. There’s risk involved, of course, but it can be mitigated.
Most credit cards have APRs around 15%, so not paying off your credit card to save money is ridiculous because combined you’re getting a -8% return, or worse.
Think of money as having opportunity cost. If you spend it to avoid a 4% loss, then you lose the opportunity to spend it on a 7% gain. A 7% gain with a 4% loss is a higher net gain than avoiding a 4% loss, though, so don’t let our human bias towards loss aversion affect your decision-making too much.
There is risk, though. That 4% interest will always be there, the 7% might not be. It’ll be higher some years, lower other years, so you need to have the stomach for that.
Types of Account You Can Invest With
Before we get to the real investing, you should know about the different main types of investment accounts.
A 401K is an investment plan offered by the company you work for. It will usually be made up of funds with high management fees, which is why it’s usually undesirable if you’re trying to maximize your long-term gains (and who isn’t).
The benefit to a 401k is the matching I mentioned before, and that it grows tax-free. So while a personal investment account will tax you for your capital gains, a 401k will not which will significantly increase your returns over time.
You only pay taxes when you take it out, and when you take it out you’ll be retired and in a lower tax bracket so you’ll pay much less in taxes.
The downside is that there’s a limit to how much you can invest in it, so you could cap it out.
While you’re with the employer you can’t move the money out of their system, but when you change employers you can roll it into an IRA (individual retirement account) which we will get to next.
The IRA is your individual retirement account. Think of it like a 401k, but… individual. Yeah.
Anyway, the benefit to an IRA is that it allows your investments to grow tax-free as well. So instead of losing ~25% of your gains each year to the capital gains tax, they just keep growing, and that results in a significant increase in returns over time.
Depending on how much money you’re making, there are a couple of types of IRAs.
A Roth IRA is ideal, since it allows you to pay taxes on the money as it’s going in, then have it grow tax-free AND not pay taxes when you take it out. This is great since taxes are at the lowest they’ve been in a long time and are most likely going up sometime before we retire.
But if you make more than $110,000 a year (Investment Banking friends) you can’t do a Roth, so you have to do a Traditional IRA. With a Traditional IRA, you pay taxes as the money is coming out, but it still grows tax-free, and depending on how much you’re making you can deduct a certain amount of your contribution to it from your income.
The IRA is more tax efficient in the long-term than a personal investment account, so it makes sense to fill it first. There are contribution limits though. If you’re under 50 you can only contribute $5,500 a year (it’ll go up in the near future) and if you’re over 50 you can do $6,500.
And once you’ve maxed that out, you have…
The Personal Investment Account.
This is the least tax efficient option you have available to you, but there’s no limit on how much you can put in it so it’s a solid place to put your money once you’ve maxed out the other options.
Essentially, this is the same as buying stocks, but you’re not going to buy stocks.
The one big benefit to a PIA is that you can take the money out anytime. With an IRA or a 401k you get penalized if you take the money out before retirement. With a PIA you can put money in and take it out when you want, so if you get stuck in a situation where you need access to your money, having some of it in a PIA can be a big advantage.
What to Invest In
The most important thing to remember with the stock market is that you can’t time the market, you can’t predict which stocks will go up or down, and 99% of other people can’t predict it either, even the people we pay to do it.
It’s tempting to think you can, “well I did a lot of research!” or believe that other people can “well he’s been successfully trading for the last 3 years” but in the first case you’re arrogant, and in the second case you’re ignoring the survivorship bias. Traders who don’t stay positive don’t keep their job very long. 1024 monkeys flipping quarters will have one that gets 10 heads in a row.
There are, naturally, exceptions, but the exceptions are the absolute best in the financial industry and good luck getting into their funds with anything less than a few million to invest.
So since we can’t pick stocks, and since other people can’t either, what stocks do we invest in? All of them.
The index fund was first created by John Bogle in the 70s after his thesis research at Stanford demonstrated that mutual funds fail to meet the expected returns of the market, and are thus bad investments.
The idea of the index fund was that his company, eventually called Vanguard, would keep a collection of the stocks that make up different markets (the S&P 500, the total US stock market, the total international stock market, etc.) and then let you invest in those indexes so that you could get returns that matched the market.
It turned out he was right, and that these index funds outperformed well over 95% of all mutual funds out there.
What’s great about them is that they’re easily purchased, managed, and we can all have access to them. And if you get your diversification right, you can have a safe average annual return of around 7% AFTER fees, which is higher than you can get with just about any mutual fund.
But just buying an index fund isn’t enough. Buying one stock is a terrible idea since you’re putting all of your eggs in one basket, but if you just put all of your money in say the S&P 500 Index Fund you’re also putting all of your eggs in one basket, in a sense.
That’s why it’s important to also diversify your asset classes.
How to Diversify
An index fund diversifies for you by spreading your investments out over a ton of different stocks or bonds, but you need to also make sure that you’re diversifying your index funds.
The entire stock market could go down over a period, as could the entire bond market. Or maybe the US stock market does well, but the emerging markets stocks perform better.
Diversification is a beast, and is how the people at the top make most of their money.
Instead of trying to figure it out on your own, I would just use a split that people much more experienced than us have figured out.
David Swensen’s portfolio (he manages the Yale endowment fund) is one of the better ones publicly floating around out there, but I encourage you to look at others as well.
Another option, and the one I prefer is to use a tool that figures out the ideal diversification for you.
Now there’s another option that nullifies needing to know much of anything about diversification, types of funds, etc. And that’s letting an automated investor like Wealthfront do everything for you.
Here’s how they work. You complete a risk profile, decide what type of fund you want to open, then they invest your money in a diversity of stocks, bonds, and equities based on your risk comfort and manage it for you. Their management fees are only .25%, so the only way you’re going to get a lower fee is if you do everything yourself.
All you need to do is keep funneling money into it, and they handle the rest.
This is especially ideal if you’re just starting out and don’t have enough money to immediately start diversifying what you’re investing in.
The downside is that you have no control over exactly what they’re buying, so if you’re further right on the technology adoption curve you might not love trusting an algorithm with your money.
First Steps and Action Items
Here’s what you need to do to get started based on the tips in this article:
- Decide how much of your monthly take-home (or paycheck) you’re going to invest. I like 20%.
- Check with your employer (this also goes for interns!) if they have a 401k. If they do, set your paycheck to automatically invest at least the match amount (5% or whatever).
- Set up a Roth or traditional IRA with Wealthfront, and just go with whatever diversification they give you for your risk profile (there are no wrong answers).
- Set Wealthfront to deduct a set amount each month from your bank account. Even if it’s just $100, that adds up fast.
If there’s anything I left out, if you have any questions, or if you want more details on any of these areas, let me know in the comments!