A Kick-in-the-teeth Guide to Investing

KICK IN THE TEETH INVESTING
SHARE

Most people aren’t rocket scientists when it comes to investing. I’m not either, but I know enough about it that hopefully I can teach you something about it in the next five minutes.

You need to know why you’re investing.

The first thing you need to do is develop a purpose for investing. Without this you’re just going to sock away money for no apparent reason. By developing a purpose you’ll provide yourself with motivation by knowing what you’ll get when you’re ready to start making withdrawals.

  • Do you want to retire decades before your peers?
  • Do you want to travel the world?
  • Do you want to start your own business?
  • Do you want to put your kids through college?
  • Do you want to sleep on a bed made of money?

Then, you need to develop a timeline. A timeline will help you understand when you’ll actually achieve your financial goals. Make sure they’re realistic and within your reach. You could then apply your timeline to each of your investing goals. “I want to retire in 10 years with $1,000,000″. This is a properly formed goal. Now you have to figure out how you’re going to get that Million bucks.

How much of your income should you invest?

I’m not going to answer this question. Instead, we can explore it a little bit, then you can make your own determination.

Let’s say your goal is to save $1 Million and you’ve decided that your timeline is 10 years. The market grows at about 8% per year (on average). And inflation eats about 3% of your money. This means that your money will grow at an inflation-adjusted rate of 5% per year on average.

By plugging in a few numbers into the MoneyChimp compound interest calculator you can see that you would need to invest $75,718.65 annually to reach your goal of $1Million within 10 years. Realistic or not, that’s for you to decide.

I will say that 20% of your take home pay is a good number to start with, but over time you should increase this amount as you become more efficient with your money. For example, I can safely invest 70% of my income every month, because I constantly exercise my ability to optimize my finances.

How to invest.

When I became debt-free I was pretty confused when it came to investing. There’s almost too much information out there and no one to simplify it. I’ll make it as simple as possible. If you’re a pro investor then feel free to not read this.

You’ve heard of stocks, bonds and mutual funds before. These may just sound like words with no meaning, but each of them has their specific purpose. Stocks are tiny portions of companies. If you own stock in a company then you own part of a company. Bonds are money that you lend organizations or governments who then pay you back over time for your investment.

I invest all of my money in either mutual funds or ETFs. These two things are pretty much the same thing, but have slightly different tax structures. Mutual funds and ETFs are ways of investing in many companies at once. They reduce volatility (extreme gains or losses), because your money is spread loaded to hundreds or thousands of companies.

Kick-Ass places to invest.

The following are my suggestions of where you should be investing your money.

  1. The first and least obvious place to invest is your 401k. This is an investment! You can invest $17,500 into your 401k this year which will shelter your money from taxes. You’ll have to pay taxes when you withdraw money, but your money will grow tax free. Pretty slick.
  2. Vanguard. Vanguard is the mecca of investing. All of their funds have extremely low expense ratios (explained in the next section). They have many index mutual funds and ETFs, as well. This means a computer picks the allocation rather than a human, which means you pay less over time. Open a Vanguard account today.
  3. Betterment. Betterment is great because they make investing extremely easy. They automatically allocate your money and create an instantly diverse portfolio for you. You don’t have to know anything to use Betterment. I’ve had an account with them for over a year now and it performs just as well as my Vanguard account. My personal Betterment returns since February 2013: 10.0% Open a Betterment account today.
  4. Prosper. Prosper is a way to crowd-source loans for people. Someone may want a $10,000 loan. As an investor I can buy a $25, $50, $100, etc portion of that loan. The borrower then pays back the loan plus interest. While this shouldn’t be the foundation of your portfolio, it can add some nice diversity. My personal Prosper returns since July 2013: 9.38%. Open a Prosper account today.

KICK ASS BY INVESTING

Terms you should know.

There is a very limited portion of investor lingo that you need to concern yourself with. Most of the other stuff is meant to confuse you and to make Wall Street employees feel good about themselves.

  • Expense ratio – The cost of operation for a mutual fund or ETF. The lower the expense ratio the better. Vanguard’s average expense ratio is 0.19%. That means they take a small cut of your money every day. The industry average is 1.11%. That means other companies charge nearly 600% of what Vanguard charges you.
  • Active vs. Index – Active management requires a human being — or a team of human beings — to decide the allocation of a fund. It costs money to pay these people, who are essentially throwing darts and making educated guesses with your money. Index funds use spiders, or robots, to decide the proper allocation. It costs less because there’s no one expecting a paycheck. Index funds reflect the market more accurately.
  • Dividend – This is free money that is distributed to you for owning shares of a fund. Think of it like a thank you. This money then gets reinvested into the fund, which provides you more shares — shares that you didn’t have to pay for. You do have to pay taxes on dividends every year.

Taxable vs. Tax-Advantaged.

There are three main categories that I’ll cover here. They are the three that I currently use, and the ones that I personally recommend.

  • 401k / TSP / 403b – These three investment options are pretty much the same thing. You can invest up to $17,500 per year of your pre-tax money here. You can access this money when you’re 59 and 1/2 penalty free. You can access your money earlier, but you’ll pay heavy fees, so I don’t recommend it. You’ll pay taxes when you withdraw from these accounts.
  • Roth IRA – This is a way to shelter an additional $5,500 per year from taxes. You use post-tax money (money that you’ve earned that’s already been deposited into your bank account), and you never have to pay taxes on this money again. It grows tax-free and you can withdraw it tax-free. The same rule applies that you have to be 59 and 1/2 to withdraw penalty free. However, you may withdraw the contributions you’ve made penalty-free at any point.
  • Taxable investing – This is where you invest the money you want to touch before you’re 59 and 1/2. You’ll use post-tax money to invest. You’ll pay taxes on the dividends and interest they generate, AND you’ll pay taxes on any capital gains or losses (these are generated when you SELL shares).

How to apply these principles.

At this point you may still not know how to invest and that’s fine. Here’s an example so you it will become clearer:

You decided you wanted to start investing $500/month so you could reach your goal of having $75,000 in 10 years. You know that in 10 years you’ll still be under 59 and 1/2, so you decided to open a TAXABLE account with Betterment.

Betterment only asks you one question: What percentage of your portfolio will be stocks and how much will be bonds? You answer by saying 100% stocks, because you’re young and you can afford short-term losses.

You set up an automatic $500/month withdrawal from your checking account every month and BOOM, you’re an investor. That’s it. Since you can reasonably expect your account to earn 5% (inflation-adjusted) per year you should easily reach your goal.

How to track your investments.

The only thing that I use to track my investments is Personal Capital. They have a streamlined interface that shows the growth of your accounts and your net worth over time. It isn’t a budgeting site like Mint, although they do track your purchases automatically which is nice.

Personal Capital is a powerful tool that can help you find hidden fees in your investment accounts — especially the tricky ones that hide in your 401k.

Personal Capital Fee Analyzer

Open a Personal Capital account today. It’s free and secure (and pretty to look at).

Crap that I avoid.

  • I don’t listen to people who try to convince me they have a way to get rich by buying or selling stocks.
  • Penny stocks. The people that buy them are misguided, and are subsequently throwing away their money.
  • Up-and-coming sectors. I don’t buy into hype, and you shouldn’t either. Broad-based index funds ONLY.
  • Sensationalism. The market goes up and down. Big media blows this out of proportion in whatever direction it’s moving. Don’t listen to these people, they’re just sensationalizing the market for ratings.
  • Emotional investing. If you let your emotions get in the way of your investing, you’ll be heartbroken when your holdings slide and excited when they climb. Leave your emotions out of it, and let the stock market happen.

Not so Kick-Ass disclaimer.

You’re ready to start investing. You know what an index mutual fund is and what expense ratios are. You know that you’ll earn money in dividends and you know you should avoid penny stocks. Blah blah blah.

Now you need to understand that you might LOSE money when you invest. Like I said, the market goes up AND down. Be conscious of this from the beginning. This doesn’t mean you should be fearful. It means that you should remain confident even during market turbulence. Recessions are eminent, but don’t let that scare you — especially if you aren’t withdrawing your money for a few years.

Don’t forget to share this article. And if you haven’t already, please subscribe below.

Cover and in post image credit (images have been modified by me): Flavio~ via Flickr

19 Comments

  1. Great article, I have joined Betterment and I am going to start throwing funds there. What level of risk do you suggest on Betterment? I am more aggressive with stocks, because of my younger age. Do you think this is a good option if I am pursuing early retirement (bigger potential returns?)

    Reply
  2. Slight error (though maybe I’m wrong): the PRINCIPLE from a Roth can be withdrawn penalty free at any time. Any capital gains, though, must be left alone.

    Slightly more complicated, but HSAs are a very efficient vehicle for post-60 retirement, since you avoid FICA as well. Pre-60 you can withdraw for medical expenses only, but post-60 you can withdraw for any reason.

    Reply
    • You’re definitely right. I didn’t really want to add that though, because it gets hairy and I wanted to keep things simple. You can withdraw contributions penalty-free at any time unless those contributions are from an IRA conversion. If the contributions are from a conversion then you have to wait at least 5 years to withdraw that money penalty free.

      Reply
  3. For the average person, is there any reason not to just invest everything into your 401k until you can max it out? Unless you are saving for a home/car/emergency account, shouldn’t you max out your retirement accounts first before considering any other investments?

    Reply
    • Depends on the tax bracket, and the choices available in your 401(k).

      My wife and I pay essentially zero/negative federal tax, so we fund the 401(k) enough to get the maximum match, but then prioritize the forever tax-free gains of the Roth.

      Reply
    • Well everyone’s circumstances are different. That’s one reason I tried to write this as simply as possible. I couldn’t possibly write a one-size-fits-all investing post.

      I believe that you should be maxing out 401k, then your Roth IRA, then any overflow should go into your taxable accounts. And if your spouse is eligible (and you have the money) they should be maxing out their 401ks and Roth IRAs as well.

      The average person that doesn’t care about creating massive investment accounts or retiring early could stick with a plan of putting 20% of their income into their 401k and be fine.

      Reply
  4. Johnny, do you know anything about the 457(b)? It’s apparently offered to many government employees. It just became available to my wife, a teacher. Here’s my understanding of it: Like a 401(k) or 403(b), you get to make contributions pre-tax, but you don’t pay a 10% penalty if you withdraw the contributions before 59.5.

    So it’s a best of both worlds scenario: if you get in a jam, you don’t lose the freedom to withdraw it; but you start off with the same benefits of a 401(k) or 403(b). Can contribute up to 17,500 each year to the 457(b), and that’s in addition to also maxing out the 401-k if you want to. In other words, you can max out both the 401(k) and the 403(b), for a total of 35K.

    I am not a tax or investment expert; please let me know if this is true. As there are many government employees among your readership, this might be worthy of your investigation.

    Reply
    • I participate in a 403b program (Educator) through my workplace. The 403b doesn’t allow penalty free withdrawals before 59.5. If the 457 does I will definitely be checking into that.

      Reply
      • Wow, I screwed up my first comment. Feel free to delete. I should not comment before I’ve had my coffee.

        What I meant to say is, you can max out your 401(k) to the tune of $17,500, and you can also, concurrently, max out your 457(b) to 17,500, giving you a combined 35K max-out between the 401(k) and the 457(b).

        Yes, there is definitely a 10% penalty to withdraw from the 401(k)/403(b) before 59.5. However, I believe there is no penalty for withdrawing contributions early from a 457(b). And that’s what makes the 457(b) awesome.

        Reply
  5. That’s a good primer, Johnny. I’m torn on Betterment. I think it’s a good tool, especially if you want to be hands off with rebalancing. But with access to Vanguard, I’m hesitant to add additional fees. Do you find the advantages of the automation make it a more attractive option than simply buying directly from Vanguard? And how do you decide how much to put in one vs. the other (e.g. – is Betterment your ‘experiment’ investment account, and your Vanguard account your ‘real’ account)?

    Reply
    • Not everybody has the money to build a great diverse portfolio through Vanguard directly. It takes about $3,000 to buy into each fund. Then you have to know what you’re doing, and know how to rebalance, and when to do it, and WHY you’re doing it. Whereas with Betterment you could have that great portfolio with $3,000 and be completely hands-off with it and they maintain it for a pretty insignificant amount of money.

      I use Betterment as an experimental account, yes. Vanguard is where most of my money is. But, it’s been a successful experiment! I wish they existed when I was starting to invest.

      Reply
  6. Very informative post. Investing used to be such a puzzle to me but it’s becoming clearer and clearer and I’m fully seeing the importance of it. Recently increased my 401k contribution rate so I’ll try to keep that going.

    Reply
  7. “…You set up an automatic $500/month withdrawal from your checking account every month and BOOM, you’re an investor. That’s it. Since you can reasonably expect your account to earn 5% (inflation-adjusted) per year you should easily reach your goal.”

    What investments do you have a position in that earn 8%/year. Are you referring to ETFS from Vanguard?

    Reply
    • I’m talking about the U.S. stock market in general. You typically won’t add 8% every year, but you will on average over the long-haul.

      Reply
      • He is correct, the market in the long run has a tendency to re-balance itself. It’s weird but true. I lost quite a bit in 2008 recession, but have since re-cooped my losses and even an avg. 6-9 % return a year.

        Reply
  8. Great article touching on many points that most people do not really know about. I like the terms section because most people do not fully understand the power of dividends and what they can create with them over time. Thanks for sharing.

    Reply

Leave a Comment.