The word investing causes some people to break out in hives. For many, it simply seems like wizardry. Still others believe it’s all a scam or gambling, or only for sophisticated money gurus. This leads people to either avoid investing or to trust people to invest on their behalf (often while charging exorbitant fees.) Neither of these is a good choice. Don’t be scared – with some basic concepts you can make your money work for you!
Welcome to the final post in the FI Basics series. (If you are familiar with FI concepts and/or the basics of investing, you may want to skip this post.) In the previous installment, we went through a quick overview of creating and securing your savings. Today, we’ll go through some basic investing principles.
Quick Disclaimer: It’s important to remember that I’m simply a financial independence enthusiast and not a certified financial planner. I’m sharing with you my experiences and personal learning but not investment advice. Please consider your personal financial situation and goals, which I cannot possibly know, before making any decisions using anything you read anywhere on the internet.
Okay, now that we are clear on that, let’s get into it. If you read the previous entry, you’ve hopefully managed to create an emergency fund and now have some extra money waiting to be deployed. That’s great – you’re already ahead of most people.
Even better – you can now use that money to make more money for you. To reach financial independence, you need to have enough passive income to fund your lifestyle. Your goal is to have enough money invested that it generates the amount you need to make work optional. You can read about how to set that target here. This may seem daunting when you start out, but you’ll quickly find that money tends to grow itself when invested.
To support your future FI success, let’s go over a few of the most important big concepts in investing for financial independence.
Time Matters – A Lot. A Lot. More Than You Think.
Time is a critical factor in investing in so many ways we’ll give it three subsections.
Time is important to your psychological frame
You must view investing for financial independence as a long game. Do not obsess over day-to-day drops, but do pay attention to long-term trends. If you focus on short-term losses, you increase the chances of making a hasty investment decision.
If you follow the basic tenets of investing, you are very likely to come out ahead in the long run. Think of investing as a matter of decades, rather than days, weeks, or even years. Even if you plan to reach financial independence in the next year or two, hopefully you plan to live for decades after.
Key: Investing is a long game. Treat it that way.
Money + Time = Winning
While not always true, this simple equation captures one of the most important investing concepts. As you invest, your money will grow faster over time thanks to the power of compounding.
If you invest early, you’ll need to invest less than if you start investing later.
To illustrate, let’s look at investing $500 monthly starting at 25 vs. 35. In both cases, we’ll assume you want to retire at 55 and that you earn a relatively modest 5% return. Using a simple compound interest calculator, we get:
Starting at 25: $398,633
Starting at 35: $198,395
That’s more than $200,000 simply by starting 10 years earlier.
If you are starting late (like we did) don’t let this discourage you. Take it as encouragement to start now and put as much away as you can as soon as you can.
Key: Start investing as soon as you can.
You Can’t Time the Market. Don’t Try.
Now, there will be a few who disagree with this. It appeals to the gambler/gunslinger/superhero culture so many of us enjoy. We all want to think we are special. In this area, you are not.
The market goes up most of the time. Sometimes it goes down. It is tempting to think you can anticipate these movements. It’s easy to be convinced that someone who dedicates their life to the market can do it for you (again, if you pay them a lot of money.)
It’s cheaper and easier to realize that virtually no one can do this consistently. So, don’t jump in and out of the market. As you build up your investing knowledge, you can deal with possible market movements in other ways. By jumping in and out, you’ll almost certainly do worse.
Key: Don’t try to time the market. Don’t pay anyone who tries to convince you they can.
Another basic, though not universally true, tenet is that risk is related to return. That is, the riskier the investment, the higher the potential return. The assumption here is that you are compensated for the chance that you will lose all your money by potentially making a lot more money.
At the most basic investing level, one can compare stocks and bonds. Bonds are generally considered less risky. They provide lower returns, but much less chance that you’ll lose all your money.
Stocks are considered more risky. Some stock values drop all the way to zero, meaning your money is gone. Over some periods, stocks in general have lost considerable amounts of money. Owning stocks is riskier. But, over time stocks have returned considerably more than bonds.
As an investor, you need to decide how much risk you are comfortable taking. You will read many different recommended investment allocations. Each of these is right for someone. But that doesn’t mean any are right for you. You will need to decide how comfortable you are with short-term losses and risk.
If you simply cannot handle any loss in the short-term, you will choose to invest in vehicles with almost guaranteed returns. These are things like CDs, treasury bills, or higher interest savings accounts. While these are “safe”, they will not accelerate your FI journey significantly. That may be okay for you.
Some in the FI community advocate for holding 100% stock index funds. This is a riskier holding that they believe will pay off over a period of decades. It has historically, but that does not necessarily mean it will in the future, no matter what you read.
You need to evaluate what level of risk you are willing to accept and make your choices accordingly. This evaluation will be tested when you incur short-term losses. That’s okay, it’s part of the journey.
Key: Decide for yourself how much risk you can comfortably accept. Adjust your investment choices accordingly.
You’ve probably heard this word in relation to investing. I’ve even had people tell me that they believe in diversifying, then confess that they don’t know what that actually means.
The concept is summed up by a common phrase: Don’t put all your eggs in one basket.
You can use diversification to minimize your risk. In fact, you absolutely should diversify even if you have a very high-risk tolerance.
Think of it this way using one of the highest risk investments: investing in an individual company.
- If you put all your money into a single company and it goes bankrupt, you’ve lost everything.
- If you spread your money into three companies and one goes bankrupt, you’ve still got ⅔ of your money.
- If you spread your money across hundreds of companies, in government bonds, and real estate, then a single company going under doesn’t have a significant impact.
A common example of the first bullet point is Enron. If you were invested solely in Enron, you were riding high…until you weren’t. At the time, no one saw it coming.
With diversification, you choose to hold a number of different investments. It’s also advised to hold different asset classes.
A common strategy is to hold a stock fund which contains dozens, hundreds, or thousands of individual companies. You are diversifying by holding ownership in more than one individual business. You could add to this a bond fund, which holds multiple types of bonds. You are now diversified by holding multiple companies, and multiple assets classes (stocks and bonds.)
Key: Invest in more than one asset, using diversification to balance your risk.
Minimizing External Money Drains is A Sure Win
While there is really no such thing as free money, there are two actions you can take that ensure you will have more money over time than if you hadn’t taken them. Since we just talked about possible losses, let’s focus on sure wins!
You have access to investment vehicles for retirement that enable you to invest using pre-tax dollars. For educators, this is typically a 403(b), which is virtually identical to a 401k. Both allow you to contribute up to a certain amount of pre-tax dollars. That means you are able to invest more.
Depending on your household income, you may also have the ability to contribute to a Traditional or Roth IRA.
Each of these has more detail than will fit into in a basics post. However, it is worthwhile to learn about these options to take full advantage.
I personally prioritize investing in pre-tax options (403b vs 457b) to reduce the amount of taxes I pay now and get as much money in the market as possible. Remember the importance of time?
Paying less in taxes, either now or in the future, means you are getting an instant benefit. If you invest pre-tax, you will be able to “see” the benefits instantly in your paycheck. Set-up a $500 pre-tax contribution with your employer payroll. Your monthly take-home pay will drop by less than $500. It feels like free money!
Key: Take advantage of tax-advantaged investing options to get tax benefits.
Fees – Don’t Run the Race While Dragging an Anchor
Another sure-fire investing win is to pay the lowest possible fee on an investment. While the fee should not be the only criteria you use to evaluate an investment, it should be part of the criteria you use to choose who and what to invest in.
Did you know that some investments charge you 2% or more simply to be invested? This means that if your investments make 4%, you pay half of that in fees! Worse, if your investments lose money you still pay the full fee.
Educators are often taken advantage of with high-fee investments. Remember those 403b and 457 options? They are typically offered through your employer. Companies know this, and also know that educators often don’t pay attention. As a result, some of the fee loads on these investments are criminal. (I’m not exaggerating – I think some of these people should be in jail.)
Fortunately, this is less true than it used to be as transparency and competition have led to more options and almost reasonable fees. Still, the traps exist. It pays to be aware. When evaluating your options, compare fees before making a choice. I try to keep fees as low as possible and absolutely avoid anything with fees at or above 1%.
Think of it as running a race. A high fee is like an anchor. You’ll make progress (hopefully) but it will be much slower than it should be. Change that anchor to a 1lb weight and you’ll barely notice it at all.
Personal capital is great for tracking your investments. One powerful tool is a
Key: Look for the lowest fee way to build your desired investment portfolio. It makes a difference.
Only Invest In Things You Understand
This could have been the first big heading, but I saved it for last because it’s important and easy to forget. Do not invest in something you don’t understand. That is simply gambling. It’s a recipe for disaster and/or getting taken advantage of.
If someone tells you that they have a magic investment that will make you easy money, do your research. If you can’t understand it, don’t put your money in. This will save you from virtually every scam.
On the less paranoid end of the spectrum – it’s just good advice to know where you are putting your money. Take the time to build a basic understanding of an asset and you will enjoy investing more. You’ll feel more confident in your choices, and you will respond better to gains and losses that happen in virtually all asset classes.
For most investors, it is best to keep it simple. Complexity does not necessarily lead to better results. Unless you dedicate yourself to investing full time, a requirement to know your investments will force you to keep it simple.
Key: Understand an investment before it gets your money.
A Common FI Investment Portfolio
Let’s take a look at a common investment portfolio discussed in financial independence circles:
- Total Stock Market Index Fund
- International Stock Index Fund
- Bond Index Fund
An index fund simply puts your money in a wide variety of stocks and/or bonds. You are buying a piece of virtually every publicly traded company. The total stock market fund holds most US companies, and the international fund holds a variety of international companies. The bond fund invests in a variety of bond types. This is easy to understand.
You are invested in literally thousands of companies, and hold bonds to mitigate stock risk. You are diversified.
If you are putting your money in and leaving it until you need to withdraw, you are investing for the long run. Time is your ally.
Typically, these funds are in Vanguard or Fidelity. Index funds at both are among the lowest fee options in the industry.
Many employer plans will allow you to access at least one of these fund types. If so, you are able to get your money in pre-tax.
You can adjust the percentage you hold in the stock funds and the percentage you hold in the bond fund to fit your risk tolerance. (More bonds is less risky.) A common weighting for the three funds is:
|Investment||% of Holdings|
|Total Stock Market Index Fund||42%|
|International Stock Market Index Fund||18%|
|Bond Index Fund||40%|
This would be considered a fairly conservative allocation but would generate significant returns in most time periods (as compared to simply holding cash.) As I mentioned earlier, there are those who advocate holding 100% in a Total Stock Market index. That is considered very aggressive.
If you want to read more about this common type of allocation, you can search for the “three fund portfolio.” This link will take you directly to a longer explanation of the three-fund portfolio. My Money Wizard also has a good explanation of the three fund portfolio here.
My Investment Portfolio
I share mine not as a recommendation, but as an example of how I try to apply the above principles. I also believe transparency is important if you are reading what I write.
Another common investment in the FI community is real estate. We own a single-family rental. I stumbled into this and definitely did not apply “Only Invest in Things You Understand.” Over time, we’ve learned enough to make me comfortable keeping the investment but have not yet added to our real estate holdings. This is just under 20% of our invested money.
For the paper asset allocation (stocks and bonds), we work to hold the following asset percentages:
- 64% Total Stock Index
- 16% International Stock Index
- 20% Bond Index
The 80% stocks 20% bond weight is mildly aggressive for our age, but not unreasonable. We are comfortable with the risk weighting, especially considering the real estate holding we have.
We hold a greater number of funds than I’d like due to the need to invest through employer options. In 2019, we will max all our pre-tax investment options this year! That makes some complexity more than worth it.
We hold the following:
|VTSAX||Vanguard Total Stock Market Index||My preferred total stock index fund|
|FZILX||Fidelity 0 fee international stock index||Provides our international|
|VFORX||Vanguard Target Retirement 2040||A diversified fund TFI prefers for her 403b holding|
|Russel 3000 Stock Index||Stock Index fund option in our 457|
|(mixed)||Bond Index Fund||Bond index fund in our 457|
At five funds, this is more complex than I’d prefer but still relatively simple. Again, the complexity is a result of certain required choices to max our pre-tax investments. All fees are relatively low. The highest fee is .35% for the bond fund, which includes a .17% admin fee. The Vanguard Total Bond Market Fund fee is lower but not available in the 457 options we have.
We hold all our bonds inside tax-advantaged accounts.
The Vanguard target date retirement fund is an option for someone who wants to achieve diversification and weighting by risk factor over time but doesn’t want to manage their own funds. You simply choose your desired retirement year, and the assets are weighted according to industry recommendation. It is a simple, solid option for many. We own it because TFI (my partner) wanted a simple diversified holding of her own.
Since we are still putting significant money in, we adjust our contributions each year to maintain our desired weighting of 80% stocks / 20% bonds.
There you have it – a quick overview of basic investing concepts. This post wasn’t meant to make you an expert, but to highlight some keys that will enable you to put your money to work for you. Keep these simple things in mind:
- Time matters
- Invest as early as you can
- Invest for the long-term
- Don’t try to time the market
- Know Your Risk Tolerance
- Diversify to manage risk
- Understand before you invest
- Minimize Money Drains
- Invest using pre-tax dollars first
- Keep fees low
I also shared a common FI investment portfolio and my personal allocation as examples.
I hope you use this information and start your investing journey. You can be succesful and build your path to FI!
Please contact me or leave a comment below if you have questions or feedback.
This is a quick overview. If you, like me, feel the need to dive in deeper, here are a few readings that I found really helpful when I was first trying to build my investing knowledge as it relates to financial independence.
There are several great sites out there. One if you’re just starting out is Investing Hero.
His book The Simple Path to Wealth captures everything in the stock series in book form! It expands upon the series and is put together in an easily readable and entertaining format. I recommend this to anyone looking to understand the basic reasons for a simple buy-and-hold portfolio. It really is a simple path to wealth. If you read this book, you have all the knowledge you’ll need to invest for financial independence.
A Random Walk Down Wall Street by Burton G. Malkiel. This is a classic book, with greater complexity than Collins’ work. It’s also very
Here is the index of the entire FI Basics Series if you’d like to explore previous entries: