Personal Finance Step 5: Invest the Gap
Greetings compadres! It’s time to talk about the most fun step in personal finance — buying companies!
You have now cut your expenses and widened the gap between you income and what you spend —>> you are actually keeping the money you earn! You have built your emergency fund with 3-6 months of living expenses. You have paid off ALL of your consumer debt!
So now you have a substantial amount of money each month that you don’t know what to do with. You don’t have to put it toward debt anymore and you have your emergency fund savings. My advice is going to sound strange, but you need to spend that extra money!
But, you aren’t going to buy leggings, drinks out, or random subscription boxes that are just a waste of your hard earned cash. You are going to buy companies. That is what investing in the stock market is. You are buying shares of a company so that as that company grows and becomes more valuable, your shares become more valuable and you could sell them for more than you paid for them - appreciating assets!
Now, some companies do not get more valuable and may even fail. This is why investing in the stock market has risk involved. You could invest in a company and then the value of your shares drops far below your purchase price. This is the reason that investing in individual stocks can be dangerous. It could also be very rewarding if that company does fantastically well. Generally, the greater the possibility of making money, the greater the possibility of loosing money as well.
But, the good news is that we can mitigate the risk of investing in companies by spreading our money out among a lot of different companies through index funds. Index funds are a collection of companies that are usually grouped by the size or type of company. When you buy an index fund, you are buying a little piece of all of the companies in that fund. So if there are 100 companies in the fund you buy, you own some of each of those companies. History has shown that, over the long run, more companies in index funds succeed than fail which means that you make money. The gains from the successful companies are more than any losses from the unsuccessful companies. Again, this is in the long term. Meaning decades. If the economy takes a turn for the worse, people stop buying things and generally all companies will do more poorly for a while. This is when the stock market drops.
The MOST important thing about investing is that you do not sell your stocks. Basically ever. When you retire you will get dividends (earnings payments) from some of your stocks and you can sell some shares if you need to to pay living expenses but only once you are retired. Never invest money in the stock market that you will need any time soon.
When the stock market falls, you do not panic and sell your shares. I repeat, do not panic! Instead you realize that the stock market is on sale and it is a good time to buy! Again, when you invest money in the stock market, that money stays there. Pretty much forever. This is called “buy and hold” and I promise didn’t make it up. Historically, the stock market returns with this strategy are 8-10% in the long run. This is how you build wealth. If your money just sits in a bank account, it actually looses value because things are getting more expensive due to inflation. To achieve financial independence, you need to make your money work for you.
Okay, so we know that when we invest money, we don’t touch it after that. There is more nuance to that advice (you may need to rebalance your portfolio), but in general once you buy stocks you hold them. Now we need to know how and what to buy.
Building Your Portfolio
The first step to getting into investing is opening up an investment account. You want to prioritize investing in accounts that have tax advantages.
If your employer offers you a 401k and any sort of match, this is where you should start. The nice thing about 401ks is that you can have the money deducted from your paycheck so you don’t even have to think about it. That money is put in before it is taxed, so you get to keep a bigger piece of your paycheck. The money also grows tax free. You won’t pay taxes until you are retired and start taking money out of the account. Then it will be taxed as normal income to you. Setting up your 401k can be confusing because often company websites are poorly designed. Make an appointment with someone from HR if you need to. The most important thing is to not have you money invested in a target date fund which will likely be the default option. A target date fund is often actively managed which means you are paying someone fees to move your money around. It also doesn’t give you any control over your investments and you are an investing expert. Target date funds are usually far too conservative, which means you are missing out on gains. You want to invest you 401k just like all you other investments which we talk about below.
IRA stands for Investment Retirement Account. A traditional IRA is set up so that you can put money in before it is taxed now, and then you will be taxed when you withdraw the funds in retirement. A Roth IRA is set up so that you put the money in after you have paid income tax, and then you don’t get taxed on it when you withdraw it later. Usually for young people, a Roth is the better choice. This is because you are probably earning the lowest you will right now which means you are in a lower tax bracket than you might be later in life -> you pay less taxes. If you are at the peak of your earning right now, a traditional IRA would probably be better for you. Roth IRAs also have earning limits - if you earn more than $122,000/year you don’t qualify to contribute to a Roth and need to use a Traditional IRA.
If you don’t have an investment account outside of your employer you need to open one- good news, you can do it in seconds from you computer! I recommend using Vanguard because personal finance gurus love Vanguard so it is easy to find Vanguard specific advice online. I have had Fidelity forever so that’s what I use and it offers the same index products, they just have different names.
For Vanguard: Follow this link
For Fidelity: Follow this link
A taxable investment account is just a normal account that doesn’t have any special tax advantages. You buy stocks with money you paid income tax on, you pay capital gains tax when you sell stocks, and you pay income tax on any dividends.
You want to max out your tax advantaged retirement accounts before you invest in a taxable account because, obviously, you want to save as much money as you can by minimizing your tax burden.
In 2019, you can contribute $19,000/year to your 401k. You can contribute $5,500/year to your IRA. So you can invest a total of $24,500 in tax advantaged accounts. (Another tax-advantaged account is an HSA but I won’t go into those here because it’s more complicated and deserves it’s own post).
After you max out your 401k and IRA you will buy funds in your normal investment account. Remember, once you invest money in a retirement account, she gone. That money will not be accessible until you are 60. Any money you put invest in your normal account should be not needed for at least 10 years and preferably not until retirement. Now if you are going to buy a house, you might need to sell some of your stocks in your normal account for your down payment. That can be fine, as long as you aren’t forced into selling them at a loss.
What To Buy
There is a lot of investment advice out there. Most of it comes from people who want you to pay them. There’s nothing wrong with financial advisors, but you absolutely do not need one. In fact, you will likely make less money from your investments if you have a financial advisor. This is because a lot of advisors make money on a fee basis- they get paid any time they move your money around buy selling and buying stocks. They don’t have any more ability to beat the market than you or I do, no one can “beat the market.” Endless studies have shown that the buy and hold strategy gives better returns in the long run than managing you funds by constantly moving things around. So you are paying someone a percent of your money to get worse returns than if you just bought and held on your own. With the wealth of information available online for free, there is just no reason to pay a financial advisor.
Remember, we are buying index funds, not individual stocks. The most simple portfolio is one call the Three-fund Portfolio and a lot of really smart people highly recommend it. I read this book on the idea and I am sold. I really recommend picking up this book- it is an easy quick read and will make you feel super confident in investing.
The idea is that you only need to buy 3 different index funds and hold them for life. It doesn’t get more simple. These 3 funds represent the entire market.
The 3 things you buy and hold are:
1) A total stock market index fund (At Vanguard: VTSAX). This fund includes giant companies, medium companies, and small companies. When you hear people talking about ‘large cap’ and ‘small cap’ they are talking about funds that hold only large companies or only small companies. A total stock market index fund basically holds all the companies on the market so you are essentially buying a piece of the US economy as a whole. This is an incredibly diversified investment.
2) A total international stock index fund (At Vanguard: VTIAX). This fund contains companies from outside the US of all sizes. It is buying a piece of the international economy.
3) A total bond market fund (At Vanguard: VBTLX). This fund contains all different types of bonds on the market. Bonds are much safer investments than stocks because they have a guaranteed return. But those returns are much lower than what you can expect in the stock market so you don’t want to have too much of your money in bonds. As you get older, you want to take less risk with your money because you will need it sooner in retirement, so you will buy more and more bonds the older you get.
How much of each?
This depends on your age and your risk tolerance. For bonds, the general advice is to take 110-age= percentage of your portfolio that should be in stocks, the rest in bonds but bonds should never go over 40%. So I am 30: 110-30= 80%. So 80% of my portfolio should be in stocks and 20% in bonds. I think this advice is too conservative for young people who are risk tolerant. I am 100% stocks and won’t add bonds into my portfolio until my late 30s.
I have about 75% of my portfolio in US stocks and 25% in International stocks. This follows most of the advice I have seen that International Funds should make up around 1/3 of your investments. Generally, International Funds will be more risky, so they also carry a possible higher rate of return.
See guys, it’s really not very complicated. You buy some of the US economy and some of the International economy and let it ride. I like to invest monthly with the money I have set aside for investments. This also keeps you from trying to time the market. Just buy your Index Funds when you have the money to do so and BAM you are an investor. I hope this was helpful and clear, please ask any questions in the comments or drop me an email in the contact box!