Accelerating your journey to financial freedom occurs in three ways:
- Earning More
- Spending Less
- Investing Efficiently & Effectively
Today we will be focusing on the third method: investing efficiently and effectively. As we are not financial advisors, we do not make any specific recommendations regarding how to invest your money. Instead, we will discuss how we personally invest our money as it is a simple yet effective investing method from which we believe anyone can benefit. We believe that low-cost, broad-based index fund investing is the best investment strategy for 99% of investors. Investing in passive index funds requires very little thought and effort, yet will still result in investment returns that beat those of at least 90% of active investment managers.
Influences of our Strategy
I first read about passive index fund investing in the book Money: Master the Game by Tony Robbins. In the book, Robbins interviews John Bogle, the founder of the Vanguard Group and creator of the first prominent stock index fund (now called the Vanguard 500 Index Fund). Bogle describes how his experience in the investment profession led him to realize that most investors would benefit not from paying high fees to managers that try to outperform the stock market, but rather by paying low fees into a fund that would mimic the S&P 500 almost exactly. His index fund contained built-in diversification by investing in 500 top-performing companies, and the fund would be “self-cleansing”, meaning if one of the 500 companies performed poorly enough to drop out of the S&P 500 it would be replaced with a better performing company. This would ensure that the fund was always invested in companies that were performing well, and the investor or money manager would not have to change a thing on their own. Bogle wrote several books on this subject himself, and the one that influenced me the most is titled The Little Book of Common Sense Investing.
From a practical standpoint, the biggest influence of our current investment strategy is the book The Simple Path to Wealth by JL Collins. Collins is an advocate of index fund investing and provides a simple yet effective blueprint on how to invest your money that we will describe further below. He also dives into the emotional aspect of investing, noting that when you “set it and forget it”, it is extremely beneficial to forget it. He describes a study that showed the highest performing investment portfolios belonged to investors that were dead, and the second-highest performing portfolios belonged to investors that forgot their portfolios existed. It is important to not let emotions get involved in investing and to stick to a plan when times get tough.
Why Fees Matter
1% of your money per year on the surface sounds like reasonable compensation to pay someone who will do the research and legwork to earn a return on your investments. However, what if I told you you still had to pay this 1% if your investment manager loses you money? Or that this simple 1% fee over a long enough time horizon would cost you hundreds of thousands of dollars in returns?
Large investment firms have made large sums of money by taking a relatively simple process (investing capital in companies) and making it so incredibly complex for no other reason than to have people pay them to navigate this “complex” world of investing. They do it for just a “reasonable” 1% fee (or more) and they try to make you think you need them to get a good return on your investments, although 90% – 97% of these managers can’t beat average market returns (depending on which study you look at). So it’s not only paying 1% per year for a likely worse performance than if you invested in the market itself, it’s 1% compounded year over year.
Let’s say we have an individual that invests $1,000 every month in an index fund over a 40 year career. We’ll say the individual’s investments averaged a 10% return each year. At the end of their career this individual will have amassed investment savings of $5,311,111.
However, if this individual invested their money with a money manager that charged a 1% fee, and the money manager was able to generate the same investment returns (which according to the odds is unlikely), the effective investment returns would average 9% a year.
So in the unlikely event that the money manager was able to keep pace with the market returns, the 1% fee the money manager was charging every year ended up costing their client $1,256,522 at the end of their client’s career career! This does not even factor in taxes, but for simplicity we will cover those effects at a later time.
How We Invest Our Money
If you were the above investor and I told you there was a simple way to invest your money and save over a million dollars, I don’t think you would need too much convincing.
We invest the majority of our money in the Vanguard 500 index fund (VFIAX) and the Vanguard Total Stock Market index fund (VTSAX) in accounts held at Vanguard itself. VFIAX mirrors the S&P 500, and VTSAX includes all 500 funds included in VFIAX plus 3,000 additional companies across different sectors of the economy for extra diversification. For all intents and purposes, you would not go wrong investing in either one of these funds and there is not a significant difference enough for us to recommend one over the other. They both have a .04% expense ratio, which as illustrated above will do wonders for your portfolio over the long term.
Why are we confident in these funds? Since the Civil War, the S&P 500 has moved in an upward trajectory, reflecting the progress of technological innovation and the resulting increase in profits that have taken place in the US economy.
You will notice that there are quite a few downturns in the graph, including the Great Depression and more recently the dot-com crash and the 2008 recession, but these downturns always turned out to be temporary and the market kept improving. This is a long term strategy, and it is important to remember that when the inevitable bumps in the road come along (like the downturn resulting from COVID-19).
When looking at your investments during a downturn, don’t think of your lower balance as you having lost money. The numbers on the computer screen may have gone down, but you only lose money when you sell those investments. Otherwise you have the exact same number of shares you had before the downturn, and you can buy more shares at a lower price. We get excited for a sale on clothes, and we should have those exact same feelings for stocks.
There are multiple options for where you can invest, and we recommend using tax-advantaged retirement accounts first, then investing in taxable accounts if you still have enough leftover.
While each individual’s situation is different, we believe most people can benefit from the following order of operations that we use for where to invest:
- Employer’s 401k Plan Match (403b for teachers, TSP for government employees) – Many employers offer to match a certain percentage of contributions made by employees. For example, government employees get a 5% match on their first 5% of their salary contributed to a TSP. This results in a 100% ROI for the first 5% contributed, which is obviously an amazing return. We recommend beginning any investment program by figuring out if your employer offers a match and making sure you are contributing enough to receive 100% of the match available. If you are self-employed, this will not apply.
- HSA – This stands for Health Savings Account, and is available to individuals that have health insurance categorized as a High Deductible Health Plan (HDHP). If you have this type of health insurance, we recommend contributing to an HSA up to the annual limit for the tax benefits and flexibility it provides. HSA contributions are both income tax deductible and FICA tax (Social Security & Medicare) deductible, and you can use funds in an HSA for most medical expenses without penalty. Additionally, you can invest the funds in an HSA with all gains being non-taxable as well.
- Traditional IRA/Roth IRA – After maxing out an HSA (if you qualify) we recommend maxing out an IRA, a Roth IRA or a combination of the two. As of 2020 you can contribute a combined $6,000 ($7,000 if age 50+). We won’t get into specifically what mix of traditional/Roth to which you should contribute as every situation is different, but investing in your own IRA in general allows more flexibility than a workplace retirement program in terms of funds in which you are able to invest. Therefore we recommend maxing this/these out before going back to your employer’s retirement plan.
- Max Out 401k (403b, TSP, SEP IRA) – Once you max out your IRA, look to max out your workplace retirement plan. As of 2020 the limit for most is $19,500 for 401k, 403b and TSP plans. If you are self-employed, you can contribute a percentage of your net profits to a SEP IRA, which works similar to an IRA aside from the contribution limits.
- Taxable Accounts – If you are fortunate enough to have money to invest after maxing out the above vehicles, you can invest in a taxable brokerage account.
Investing Closer to Retirement
As two individuals that are late-20s/early-30s, we are able withstand stock market volatility. We know that if we invest everything in stock market index funds and the stock market dips, we know we will have time for the prices to recover before we need to access that money. However, if we were closer to the point where we would not have a steady income stream and would be living off our investments, we would need to make some adjustments. Although we would have a good amount of our investments still in stocks, we would adjust our portfolio to include less risky and more consistent investment payouts. Some examples that we would consider are included below:
- Allocation to Bonds – The easiest method of reallocation is to move your money from stock index funds to bond index funds. Like the stock index funds, bond index funds invest in a basket of various types of bonds. Bond funds pay out a fixed amount of monthly interest at the end of every month, which would be best used to fund your life in retirement. This provides you a hedge against a potential drop in the stock market, meaning you wouldn’t have to sell as many stocks to fund your life in a down market and end up draining your investments quicker than you would like.
- Allocation to Real Estate – If you don’t mind being a landlord and dealing with the headaches that can come with holding that title, investing in rental real estate can be a very lucrative way to diversify your investment portfolio. Rental real estate can provide (tax-advantaged) income every month, while at the same time potentially increasing in value if you decide to sell down the road. You can also invest in Real Estate Investment Trusts (REITs) to get some of the benefits of real estate without many of the costs and headaches.
- Paying Off House – As a general rule, you should never retire with a mortgage. If you still have a mortgage and are nearing retirement, consider paying off the mortgage using your investments and considering it as a “fixed income reallocation”. Although you won’t actually be making any money, the amount you will save from not having to be paying the mortgage will act as “fixed income” because you will not have to draw from your investments any longer to pay for what is likely your biggest monthly expense. Think of the phrase “a penny saved is a penny earned” in this instance.
- Being Flexible with Spending – A retired person’s budget should have built in flexibility around market conditions. For example, if someone has just retired and there is a big market drop, it may make more sense to hold off on taking an expensive vacation or being a big charitable contribution. This will give the market more time to recover so that (like #1) investments aren’t sold at a loss and drained more quickly than is optimal.
To sum up everything above: invest in low-cost index funds and avoid taxes and fees where possible. If you have money you’d like to invest in individual stocks or companies, we recommend keeping the amounts to a small percentage of your portfolio. When you look at the life-span for individual companies, you’ll realize that those kind of investments resemble gambling far more than they do investing. You could bet that your favorite team will go to the Super Bowl (stock picking) or you could bet that the Super Bowl will occur (index investing). I know where I’d put most of my money when illustrated in that way.