Personal Finance Basics, part 4
Investing made simple
In case the title didn’t make it super obvious, this is part of a series. If you haven’t read the others, start here.
So, you’ve been tracking where your money’s going, you’re spending less than you earn, you’ve got a bit of an emergency fund saved up…what now? The next step in your financial journey is learning how to invest. This is the complicated one - the one that the financial industry says “oh no, my friend…you’re not savvy enough to do this yourself, you need to pay us to do it for you.” Bullshit, I say.
Investing can be quite simple. It can also be quite complicated…but for most of us, simple will do just fine. If you’re a multi-millionaire who wants to expand your portfolio into derivatives and private equity offerings and whatever other esoteric investment options are out there, you’ll want a financial advisor. But for 95%+ of people, we can get down to just the basics.
There are about a million different things you can invest in…stocks, bonds, precious metals, real estate, cryptocurrency, even esoteric things like art or wine. But since we’re simplifying, most of us will primarily be investing in stocks and bonds (crypto is its whole own weird thing and worthy of its own post - for now let’s just say it’s extremely high risk, but possibly high return). The TL;DR here is that when you buy stocks you’re buying a (very) small portion of ownership of a company and when you buy bonds you’re buying the debt of a company and they will make payments to you.
What should we expect when we invest? Well, we can look at historical averages…
Over a very long period of time (roughly a century), the stock market has returned about 10% per year.
Bonds tend to be more around 6.5% or so, but they tend to be less volatile than stocks (i.e. they’re a bit safer but you’re going to earn less on average).
General wisdom is that you want more of your investment portfolio in stocks when you’re younger (because you have more time to make up for a market downturn and the higher overall return wins out) and more bonds when you’re older (because you’re closer to retirement and want less volatility, you want safety at that point). In other words, at one point in your life you are focused on accumulating wealth, while at another you are focused on preserving and protecting wealth. If you’re younger and plan to work for at least 20 more years, having 90-100% stocks is totally fine, but you also need to consider your own peace of mind. There isn’t a wrong answer here, really. Sleeping well at night and not stressing about your investments has value.
Now it’s going to get just slightly trickier. Most of us aren’t going to be buying individual stocks and bonds (or at least most of us probably shouldn’t). It’s fun to try to find the next Apple or Nvidia, but we have decades of data showing that most people who try to buy individual stocks themselves end up doing very poorly - it’s a tough market to beat. If you want to do it with a small portion of your money, have at it. It can be fun. But for most people, the bulk of your money should be invested in some kind of fund.
A fund is a collection of stocks and/or bonds, so instead of trying to pick and choose individual stocks, you’re buying a fund that owns a lot of stocks. There are two types of funds to know about:
Actively managed funds are run by very smart people, generally with MBAs and fancy suits. They try to pick and choose good investments to own and try to deliver strong investment returns. These people want to be paid well (gotta pay off those Ivy League student loans and afford the yachts), so you tend to pay fairly high annual fees to own actively managed funds.
Passively managed funds (also known as index funds) are run by computers. We’re not talking AI here - the computer isn’t trying to pick “good” investments - they’re just tracking some kind of index. When you hear about things like the Dow Jones Industrial Average or the Nasdaq or the S&P 500, those are indexes, and index funds just try to replicate the performance of the index. Because they don’t have an army of highly-paid MBAs running them, you as an investor pay a very low annual fee to own index funds.
Which are better? Well, while in a given year some actively managed funds will do very well, we have decades of data telling us that in general index funds beat the crap out of actively managed funds, especially once fees are taken into account. The financial industry LOVES to market actively managed funds to us, because they get to charge more money for them. And so they pick and choose the ones that have done really well lately - and it’s very tempting to say “ooh I want that one, look at how much money it made last year!” Problem is, past performance is no guarantee of future results, and when it comes to actively managed funds there appears to be no consistency of outperformance. In a given year, some actively managed funds will do well, but the majority will not. Over a longer period of time (5 years, 10 years, etc.), the vast majority of actively managed funds are outperformed by simple index funds.
At the end of the day, “beating” the market has proven to be incredibly hard, even for sophisticated, experienced investors. Simply tracking the performance of the market at low cost and with little to no effort is the best path for most individual investors (if you remember nothing else from this post, remember this).
So for our “simple investing made easy” strategy, we can now drill all the way down from the entire universe of stuff you can invest in to something much narrower: give us index funds.
But which index funds? Index funds have become quite popular in the last few decades and a lot of companies now offer them - you can buy them directly through the issuing company, or you can buy them via an online brokerage account. Either way works. Again to keep it simple, I’m going to use Vanguard as an example. Vanguard is the company that pioneered index funds is still one of the leading issuers of them, so lots to choose from, they’ve been around for ages and are reliable, etc. But if you prefer Fidelity, or Schwab, or whoever else, there really isn’t a huge difference between them.
Because index funds have become so popular, there are now a large array to choose from…possibly too many to make it easy. You can get an index fund that only focuses on technology stocks or food stocks, or that only invests in small companies, or that only invests in international stocks. None of this is bad, but again to keep it simple, we want to look for some that invest in the “biggest” sectors of the market. If our goal is to track “the market,” we should try to define “the market” as broadly as possible.
I’m going to try to make this SUPER simple (sorry to those who are at least somewhat familiar with this stuff, but trying to reach people who know nothing about investing). Here are a series of steps to find Vanguard’s index funds:
Google “Vanguard index funds” and click the top result, or just go to this link.
You now see a LOT of index funds in a list. Note the expense ratio column and how it’s (way) under 1% - this is the yearly fee you pay to own the fund. For actively managed funds, the fees are generally at least 1%.
Near the top you’ll see one named “500 Index Fund Admiral Shares,” or VFIAX. That tracks the S&P 500, one of the major U.S. stock market indexes. That’s a good one to invest in (the “Admiral Share” thing is just about the amount of money you invest - if you invest a larger amount with Vanguard you can get Admiral Shares, which have a slightly lower expense ratio, but there’s a version of the exact same fund for smaller investors).
If you keep scrolling down you’ll find another one, the Vanguard Total Stock Market Index Fund (VTSAX). This is the single broadest index fund I’m aware of - while the S&P 500 is made up of 500 of the largest companies in America, VTSAX also adds smaller companies. If your goal is to track the market, this is the probably the best definition of “the market” you’re likely to find.
Finally, Vanguard offers bond funds as well. The Vanguard Total Bond Market Index Fund (VBTLX) is the bond equivalent of VTSAX. Tada!
Andddd that’s it. This is the most complicated subject of the personal finance basics series, and if you really want to dumb it down to the simplest possible case, you can distill it down to this: a solid investment portfolio can be made up of just one stock index fund and one bond index fund.
Look, I’m not saying there isn’t value in learning more about investing. It’s a big and complicated subject and there’s a ton to learn. But this series has been about keeping things simple, so you don’t have to spend much time or energy thinking about it, and the simplest thing is a portfolio of index funds in which you just put some money every month no matter what. Speaking of….
Remember how you now know your monthly spending, because you’re tracking it diligently (or rather a nice automated tool is doing it for you)? Cool. You can now decide how much you want to invest each month. Pick a number and you can set up automatic contributions every month. That way you buy no matter what the market is doing, and you just don’t have to think about it. It happens on autopilot. You won’t get rich overnight, but you will make money over time this way.
Fun with stats: if you invest just $100/month at a “normal” rate of return, in 30 years you’ll have about $228,000. Now that’s sort of a fake number because it doesn’t adjust for the impact of inflation on your purchasing power, but if we take out a normal rate of inflation, you’re still at about $125,000. From just $100/month. This is the power of compounding - time becomes your friend. And so, investing ASAP is super important. If you haven’t started yet, get going!
Ok, this was a lot. I’m going to do a little summary here just to wrap things up and try to pick out the most important parts without the fluff:
Pick a provider of index funds (Vanguard, Fidelity, Schwab, etc.) and sign up for an account.
Decide on the balance between stocks and bonds that you want (generally somewhere between 50 - 100% stocks, the rest bonds).
Set up automatic monthly contributions so you don’t have to think about it.
Sleep well at night.
The financial industry makes a ton of money every year by convincing people that this stuff is too hard for them and they need to pay an expert. It’s not. You can do this on your own - at least until you’ve made a bunch of money. Once you get to the 7 figure mark, it may make sense to at least check in with a financial advisor and get another perspective on how things are going.
This wraps up the personal finance basics series. I hope it’s been useful and thanks for reading!
With the strategy outlined, one should also be reinvesting dividends/interest automatically back into these funds (assuming not yet at age where need the income from these funds to support lifestyle)