In this video, I explain that it’s possible to make $1 million even without an extraordinary income — if you harness the incredible power of compound interest over a long time period.
“Getting rich slowly” isn’t rocket science.
In this post I’m going to give you a nerdy step-by-step for exactly how a person might hypothetically accomplish this savings goal. Time is more valuable than money in many respects, and we’re going to use time as our tool.
Legally I have to tell you that this is not intended as investment advice for any specific person and that past performance is not a guarantee of future results.
That said, I’m certainly practicing what I preach and it’s working quite well. So let’s get started.
Step 1: Take advantage of tax-favored retirement savings accounts
By law, Congress has established a handful of savings vehicles that you can use to save for retirement. They are:
401(k)s —These savings plans are set up by businesses for their employees to use. Not every job offers one but if yours does, check to see if your company will “match” some percentage of any contribution you make. This is essentially free money, and if you’re turning this free match contribution down by not taking advantage of it, you’re making a costly mistake.
IRAs — Like 401(k)s, Individual Retirement Accounts or IRAs are tax advantaged savings accounts. The difference is you set these up yourself without an employer so they’re a bit more flexible in terms of how you invest.
You can open one of these retirement savings accounts accounts or both. Each of these types have annual contribution limits (for the employer sponsored plans the 2018 limit is $18,500; for IRAs it’s $5,500 per year). If you can save more than these amounts that’s great, but you should aim to max them out before you resort to opening additional taxable investment accounts.
(One asterisk to this rule is if your employer offers a 401(k) plan with a matching contribution… but limits your investment options to lousy high fee investment options — more on this in Step 3. If that’s the case, you should contribute to your 401(k) up to the amount that your employer will match and then open a more flexible IRA of your own.)
Step 2: Set up automatic monthly contributions
The market goes up and it goes down, sometimes in the same day. This means it’s possible that we could theoretically make investments one day and then watch the value of our investments shrink immediately. It happens! But since we’re young and we have a long time horizon, we’re not interested in the day to day market movements.
The strategy we want to employ is called dollar cost averaging. Here’s how Investopedia explains it:
Dollar-cost averaging (DCA) is an investment technique of buying a fixed dollar amount of a particular investment on a regular schedule, regardless of the share price. The investor purchases more shares when prices are low and fewer shares when prices are high… no one can time the market. DCA is a safe strategy to ensure an overall favorable average price per share.
Essentially by setting up monthly automatic contributions from our paycheck or bank account straight to our investment account, we’re minimizing the risk of dumping in a whole bunch of money while stock values are high right before they go down. Most banks and investment accounts can schedule free recurring transfers on any particular day of the month that you choose (like, right after pay-day!). For many people this is a great choice.
How much should you save per day/month/year? This answer will be different for everyone. In my video above I used the example of saving $395/month which is the equivalent of saving $13 per day. Using a 7% interest rate and a time horizon of 40 years, that gets you to a million and change. If you’re older than my example age of 25 or you want to aim for retirement at an age different from 65 you might want to set aside more or less money. And while you might not be quite able to hit my example $4,745/year savings goal when you’re younger, if you can save more the older you get, it will all even out in the end.
Step 3: Choose how you want to invest
People often think that choosing what to invest in is the hardest part of investing. It is certainly important, but it really doesn’t need to be difficult.
Today there are basically two investment philosophies. People either:
- Try to make as much money as possible by picking individual stocks and actively managed mutual funds;
- Invest in low risk, low management fee index funds that aim to merely duplicate the market performance as a whole
There is an emerging consensus among experts that for most folks the second approach (“passive investing”) is not only far safer — but it’s actually more profitable as well.
Nobody can predict which individual stocks will go up or down. In fact experiments have found that stock portfolios chosen by monkeys have been able to out-pick the professional stock pickers! And while those professional stock market gurus are moving money around, constantly buying and selling stocks, they’re also unfortunately exposing themselves and their clients to transaction fees and taxes on gains.
A simple buy-and-hold passive investment strategy on the other hand is much more tax efficient. Compared to a mutual fund that outperforms the market occasionally and underperforms the market the rest of the time, getting a pure “average total market return” is actually pretty good.
As I mention in my video, since about 1950 the S&P 500 Index (a good proxy for the stock market as a whole) has returned about 7% after you adjust for inflation. That’s better than many mutual funds can consistently offer. As I write this post, the S&P500 Index has gone up about 11% in the last 12 months. Meanwhile the HFRX Global Hedge Fund Index which measures how the pros do, has returned just a measly 4%.
One of the wealthiest investors of all time, Warren Buffet explains:
“By periodically investing in an index fund, for example, the know-nothing investor can actually outperform most investment professionals.”
So, what are we looking for? Low fee index funds that replicate the performance of the market as a whole.
Index funds are like buckets: they hold a variety of stocks so you’re not vulnerable if just one company does poorly. What makes index funds special and distinct from a regular mutual fund is that index funds track, well, an index. For instance the index might be the S&P 500 Index or the Wilshire 5000 Total Market Index (or it might track a specialized index like NASDAQ Biotechnology Index which is comprised of… wait for it… biotech companies).
Academics who study investment science have generally concluded that putting your money into broad market index funds is both simpler and safer than investing in individual stocks.
So what does the low fee part of “low fee index fund” mean? Companies that bundle index funds together charge you an annual management fee in exchange for giving you the convenience of “buying the index” instead of having to separately buy stock in, say, all 30 companies that comprise the Dow Jones Industrial Average index. So what is considered a low management fee for an index fund?
You might think a 1% or 2% management fee sounds reasonably low but among serious investors looking for value, those percentages are almost criminally high! Instead we’re looking for index funds that have expense ratios more like 0.04% or 0.1% or 0.25%.
The reason we’re going to insist on low cost index funds is that for every percent that a management company charges you, that’s one percent less than the average stock market return you’re getting. In other words, if the market as a whole goes up 7% one year, all of a sudden our returns are only 6% because the fees ate into our profits. A small difference of 1% can add up many thousands of dollars over a lifetime.
What are some examples of low cost index funds?
Index funds are a relatively new idea: they’ve only been around since 1974. But today as investors have become smarter they’ve started demanding these investment products so we have plenty of choices. Here are some examples of low cost index funds:
- Vanguard Total Stock Market ETF (ticker symbol VTI): Aims to replicate the performance of the total US stock market by holding shares of over 3,000 companies. Management fee: 0.4%.
- Fidelity Total Market Index Fund (ticker symbol FSTMX): With holdings of 3,000 US companies, this fund tries to track the entire US stock market. Management fee: 0.09%.
- Schwab International Index Fund (ticker symbol SWISX): Provides exposure to over 900 non-US companies for diversification. Management fee: 0.06%.
Many brokerages also now offer commission free ETF trades on a limited selection of funds which means you won’t have to pay a fee of $9.99 each time you contribute to your portfolio (otherwise commission fees can add up a lot over time!). Providers like Vanguard, a popular investment house, give you commission free trading on their own index funds which is a great option.
Another option: target date funds
Ideally every investor should check their portfolio and periodically make sure their allocations (investment choices) are in line with their goals. But some investment houses are now starting to offer target date funds which automatically rebalance between stocks and bonds. Vanguard’s target date funds are a great example of this. You choose which approximate year you want to retire (say, Vanguard’s Target Retirement 2045 Fund VTIVX). Then over time the management company will gradually shift your assets from stocks (more risk but more profit) to bonds (less risk, but less increase in value — so more appropriate for people nearing retirement age).
Frequently asked questions
“I’ve heard the market is down and everyone is talking about how we might be headed towards another recession. I should sell my stocks, right?”
No! If your index fund investments are down, these losses are only theoretical unless you liquidate them. When you sell in a down market you are locking in your losses and turning them from an “on-paper” loss into a “real” loss.
But if you stick with a strategy of dollar cost averaging — continuing to make your regularly scheduled investments and, maybe even increasing them a bit — you’ll likely do really well over the long run because you’ll have accumulated more shares when they’re “on sale” at lower prices. When people try to time the market they almost always screw it up. Billionaire investor Warren Buffet advises you to instead be “fearful when others are greedy and greedy when others are fearful.”
It takes real courage to keep buying when everyone else is panic selling. But because there’s no way to predict when the market will “reach bottom” before it starts going up again, often the smartest thing to do is to ride it out so you don’t miss out on those gains. Even if you were to invest at the worst possible times right before market crashes, you’d still end up way ahead if you just held on to your investments and didn’t sell when things went down.
On the other hand if a person were to sell in a panic once things go down, they’d not only lock in your losses, they’d also miss out on the biggest opportunity for gains (on the upswing afterward). When the market starts to creep back up, that same nervous investor will probably wait until it’s pretty high before he or she starts buying into the market again, just to be sure it’s not on the verge of another crash. They’d be literally selling when things are low and buying when things are high. That’s a bad strategy.
“What about investing in gold? Is that a good idea?”
Not really. Gold and other precious metals do tend to temporarily spike in value when normal equities like stocks go down a lot. But these spikes are often short lived and the long term appreciation of gold is really not that impressive. (Some wealthy investors use gold as a sort of speculative hedge against market uncertainty, rather than a true long term investment.) Take a look at this chart of the value of gold versus the US stock market and you’ll understand why many serious investors roll their eyes at people obsessed with gold, sometimes called goldbugs:
Gold’s returns over the long run have been fairly poor and somewhat erratic compared to the stock market as a whole which, despite the occasional setback, steadily rises. The people who are really making money off of gold these days are the companies who make those “CASH4GOLD!!!” TV commercials that trick grandmas into parting with their jewelry for a lower cost than it’s actually worth at any given time. Yuck.
“Should I get a financial advisor?”
You’re probably fine without one. With a few hours of research, most people can set up a savings system for themselves with no need for a financial advisor. And skepticism towards financial advisors is often warranted: advisors sometimes collect a large management fee for their services as a percentage of your overall portfolio. They can also steer you towards products that pay them a high sales commission (and these investment products often charge you high management fees to handsomely compensate the salesmen, err, “financial advisors” who push them). There are a lot of snake oil salesmen out there.
If you really do need help from a pro, look for a fiduciary advisor who has an actual obligation to make recommendations that are in your best financial interest. Instead of siphoning off a percentage of your portfolio for themselves or steering you towards investment products that give them kickbacks, a good fiduciary advisor will meet with you in exchange for a flat consulting fee of, say, $150/hour. That might sound like a lot, but it’s actually a lot less than 1% of your portfolio for a decade.
“Is it okay to withdraw money from my IRA or 401(k) before I retire?”
It’s far from ideal. When you sign up for a retirement account you are essentially getting a benefit (a tax-advantage) in exchange for promising not to take the money out before you reach retirement age. There can be tax penalties if you do, and retirement savings accounts are not meant to be used as emergency funds. It is important to save up an emergency savings fund in addition to retirement savings, not instead of it.
Tools you can use
Books: I recommend visiting your local library and checking out two very dangerous books that may change your outlook on life. The first is The Millionaire Next Door, which outlines in a very readable way how frugality can pay off. The second is A Random Walk Down Wall Street, which explains the investment philosophy I’ve outlined above in much greater detail and gives you a fun whirlwind tour of investing fundamentals.
Compound interest calculator: Run your own calculations and estimates. http://www.helpfulcalculators.com/compound-interest-calculator
Brokerages/IRA providers: I like to recommend Vanguard for three reasons. First, it’s investor-owned, a bit like a co-op, and thus everything they do is for their customers’ benefit, not outside shareholders. Second, their index funds are some of the lowest cost options around. And finally, since Vanguard was the company that invented the very first index funds in the 1970s, they now have huge amounts of experience and a great number of index funds to choose from (in fact today they have become the largest provider of mutual funds so you’re in good company). https://vanguard.com/
Online communities: You can find answers to additional questions you might have on these sites. I suggest either subscribing or periodically checking them to stay informed:
https://www.reddit.com/r/personalfinance — A community devoted to helping people get their financial houses in order and answering questions.
https://www.reddit.com/r/investing — Not everyone on this subreddit agrees with a low cost index fund investment philosophy, but many do.
https://www.reddit.com/r/financialindependence — For those of us who dream of achieving financial independence and retiring early.
https://www.bogleheads.org — A forum devoted to following the wisdom of Jack Bogle, the founder of Vanguard Investment Group.
Let’s wrap this up
The goal of saving a million dollars is ultimately random and arbitrary. Plenty of people have comfortable retirements with much less money. And many folks have miserable retirements with much more money.
The hard truth is, not everyone has the ability to save up a million dollars using the methods I’ve outlined here. Many young people are burdened with unconscionable amounts of student loan debt which delays their ability to get started. Health problems can spring up without warning and cost us both time and money. And many of us are stuck in low wage jobs where we are unable to save the amounts of money needed to really take advantage of compound interest. Income, education, and opportunity are still major barriers for many of us.
There is no magic wand solution to the fundamental wealth inequality that plagues America today. Although if we ever start turning out to vote we would actually outnumber the baby boomer generation that created or exacerbated many of these problems! And there are solutions to many of these systemic problems that lie in public policy. (That’s fodder for a whole other post though…)
But I hope I’ve at least provided a template here that you can use to start your own research and journey towards saving for retirement. If you’re still relatively young, you’re in an enviable position — even if you don’t have a lot of wealth just yet. Don’t wait another day. You can always make more money. But making more time is a lot harder.
This is the third in a series of monthly video essays I’m publishing. Here are the earlier video essays:
You can leave me terrible comments about my stock photo choices on Twitter, Instagram, or YouTube where I’m posting one video essay each month. I publish a monthly newsletter which you can sign up for at arlenparsa.com