Financial Advice I Wish I Knew in My 20s — Part 3: Investments

This is part three of a five-part series. Make sure to read Parts 1 and 2 first, if you haven’t already.

Invest Early and Often

But wait, you say, even if I spend less and save more, how the heck do I become a millionaire saving $10,000 a year? That’ll take 100 years and I’ll be dead by then!

Enter investing.

Photo by Eberhard Grossgasteiger (some “enhancements” by yours truly)

When I was younger, I knew nothing about investing beyond hearing about the loads of money our parents lost in the dot-com bubble and the general shittiness that resulted. It instilled the mentality that the stock market was gambling and you could lose everything if you were unlucky.

Turns out they were just doing it wrong.

Done right, investing is not only absolutely safe but also the easiest and most reliable way to become a millionaire on a regular salary. I’ll set out a few general principles and then provide some practical advice for getting started.

All You Need Is Time

The stock market in the United States has historically grown in value by an average of about 10% each year for the past 80+ years. At this rate of growth, any money you invest (even if you didn’t add to it) would double roughly every 7.2 years.

This snowball effect has incredible repercussions on your savings over time. If you had saved $10,000 every year and invested it in the US stock market, on average, you would be sitting on a little over a million dollars after 25 years. Amazingly, only $250,000 of that $1,000,000 would have been money you had personally put in!

If you find this difficult to believe, I’m with you. But the math doesn’t lie:

In case it’s not clear how everything adds up: The total in column B is multiplied by 10% to get the gain in column C. The two are added together in column D. On subsequent lines, the total in column B is simply the addition from column A added to the previous year’s total from column D.

At first, the 10% increase doesn’t amount to much, but by year 8 it’s already contributing more to your yearly growth than the $10,000 of your own money you put in. In the last ten years, you earn over 8 times as much as you earn in the first ten years!

If instead you had procrastinated for ten years before you started saving, you would have to save $31,000 each year for 15 years to reach the same goal by year 25. That’s $465,000 of your own money (not to mention a dramatically harder savings goal to reach each year).

Starting 10 years later…

Increasing your savings changes your timeline dramatically, of course. If you managed to instead save $20,000 a year, for example, you’d reach the million-dollar milestone in a mere 18 years.

Feel free to check out the spreadsheet I used to run these calculations and play around with some different assumptions, including what might happen if you increased your savings each year.

Don’t Put All Your Eggs in One Basket

In any situation with uncertain outcomes, diversification is one of the best ways to limit your risk.

Betting on any one company is pretty risky. Even the best companies can unexpectedly implode with some scandal or simply fail to stay relevant in the face of relentless competition. RIP, stock prices.

Betting on all the companies within an entire industry is a little safer. One company’s failure often means a competitor’s success, and over time most industries tend to grow and expand. Nevertheless, we’ve all seen certain ones rise and fall as regulations and circumstances change. (Oil, anyone?)

What if you zoomed out even further and bet on the collective success of all of the companies with publicly tradable stock in the entire economy? By doing so, you establish a position where it is simply impossible to lose in the long run. If you somehow did, it would mean that the entire economy has also collapsed in some sort of world-ending calamity, at which point everyone is basically fucked and you’ll be worrying a lot more about nuclear fallout / starvation / zombies than how much money you have in the bank.

Obviously, no one except professional traders have the time or resources to buy hundreds or thousands of individual stocks, but thanks to index funds, anyone can do just that with a few clicks of a mouse.

The Power of Indexing

There are a number of institutions that compile representative collections of companies that together form a benchmark for performance of the broader economy. For example, in the United States, the S&P 500 index represents 500 public companies selected by economists to represent the general US economy. These companies tend to be the largest and most successful companies in their respective markets and comprise the majority of stock trading activity.

Today, various mutual funds exist that essentially buy stock in the companies on these indices in equal proportion to their slice of the index. By buying these mutual funds you are essentially buying a tiny ownership stake in the finest companies around.

Don’t Fuck With It

If the stock market always goes up, why do so many people lose money?

One of the easiest ways to set yourself up for failure is, ironically, paying too close attention and trying to predict when the market will rise or fall in an attempt to get ahead of it. This is a fool’s errand.

Don’t believe me? Try this game and see how often you successfully do better than simply not doing anything at all.

The stock market behaves completely irrationally, and while it consistently trends upwards in the long run, it is practically impossible to predict its short term performance based on even the best data available.

To make matters worse, human brains are naturally wired to be greedy when times are good and avoid loss when things turn for the worse. This tendency prompts us to buy when prices are going up (FOMO!) and sell in a panic when prices begin to plunge (cut your losses!). This sort of meddling is extremely counterproductive and costly.

Even while intellectually knowing that you should buy when everyone else is selling and sell when everyone is buying, it’s nearly impossible to counteract your natural instincts to actually do so. Just ask anyone who had significant money invested before the Great Recession in 2008.

The next best option is complete ignorance. If you don’t pay attention to what’s going on, you won’t be prompted to act in one way or another and you’re practically guaranteed to do better in the long run. It’s a shockingly simple but effective strategy.

Consistency Is Key

One of the best ways to ensure discipline when investing is to do so at regular intervals regardless of how the market is doing. By doing so, you actually make the most of the natural ups and downs of the market, automatically buying more shares when the market is down (when stocks are relatively undervalued) and buying fewer shares when the market is overpriced.

This approach is called “dollar-cost averaging” and further counters the emotionally-driven temptation to buy more when the market is rising and buy less when the market is falling.

How Do You Get Started?

The easiest way, and what I recommend for most people, is to use a service like Wealthfront or Betterment, which will determine the most appropriate mix of underlying investments given your age and risk tolerance and automatically invest each deposit you make for a low 0.25% fee (that’s $25 a year for every $10,000 you have invested with them).

Their platforms are also designed to minimize meddling, which is arguably the most valuable part of the whole thing. I use Wealthfront personally, because they manage the first $5,000 you invest with them for free if you use a referral link. (It’ll also get me an extra $5,000 managed for free, so thanks if you do!)

For people who are interested in getting more hands on, I highly recommend using Vanguard. They are the original company that pioneered index investing and they have consistently prioritized minimizing their fees for the benefit of their customers. They have hundreds of funds available that allow you to choose various strategies, but you can’t go wrong with an index fund of the overall US economy (VTSMX) or even the entire world’s stocks (VTWSX).

You can certainly get a little fancier and diversify even more broadly, but I’ll save that discussion for a future article.

Remember to Keep Your Costs Low

Whatever you decide to do, avoid financial planners, actively managed mutual funds, or anyone or anything that charges more than a 1% fee for their products or services. It’s rarely worth it at that price. A 1% fee might not sound like much, but it’s enough to shave off literally hundreds of thousands (!!!) from your life savings in the long run.


Think Twice Before Buying a House

There’s a strong bias from many people that buying is always better than renting. “Renting is like throwing away money” is a common mantra and while that is true to some extent, you really have to do the math to see if buying is actually the better option for you.

Some Common Misconceptions

One of the most popular justifications for buying a home as an investment is because homes (more specifically, the land they’re built on) is a finite resource that will rise in demand as the population grows. While this logically checks out, it fails the ignore the opportunity cost of tying that money up in a down payment for a home. In other words, there are often other ways to deploy that money that can yield better returns. Here’s one comparison:

Personally, I’ll go with the black line.

There’s also something comforting about owning a physical asset that you can see and touch and form an intuitive judgment of its value. It’s a lot harder for people like you and me to understand the nebulous value of owning a small fraction of a company through stocks.

Finally, there is a major recency bias fueling the perception that home prices not only always go up, but go up quickly. Home prices skyrocketed in the late 90’s and 2000’s, only to come crashing down to earth in the 2008 financial crisis. One look at the chart below from 2006 should show what a major historical anomaly this was. Betting this will continue to happen over time is risky at best and foolish at worst.

This only shows data up to 2006, but housing prices today are still at relatively elevated levels.

Why Houses Actually Kind of Suck as Investments

Aside from historically subpar returns compared to stocks (at least in the US market), what other qualities of a house make it a poor investment? Let me count the ways…

  1. By nature, it’s completely undiversified: It’s a single asset, attached to a single location, and any number of factors outside of your control can erode its value (bad neighbors, pests, uninsured natural disasters, et cetera).
  2. It’s extremely illiquid: Finding a buyer for it can take months or even years, especially in a down market. And all that time you still have to pay your mortgage.
  3. High transaction costs: Typically, 5-6% of the sale price goes to the real estate agents involved in settling this extremely complex transaction. This means your property value must increase by at least 5.3-6.4% in order for you to break even.
  4. Expensive upkeep: A common rule of thumb is to budget anywhere from 0.5%-1% of the cost of the home each year for repairs, not to mention the cost of property tax, insurance, and HOA fees, which never go away.
  5. It’s largely financed using debt: Debt, as we discussed, is compound interest working against you. A $250K loan to buy a home, paid over 30 years at 4% interest results in a total cost of nearly $430K! In other words, you end up paying 72% over the value of your original loan in interest.

So When (or Why) Should You Buy?

In most cases, a good rule of thumb is to avoid buying if the cost of the home is 15x the annual cost of renting the same home or more. For example, if a home costs $2,500/mo to rent, you’ll pay $30K each year on rent. If the home costs more than $450K to buy (15×$30K), it’s better to keep renting.

All that being said, being a homeowner is not without its perks:

  • You can truly make it yours and tailor it to your tastes.
  • Homes built for sale are often nicer than ones built as rentals, and there’s generally a broader selection that makes it easier to find a good fit.
  • The interest payments can be deducted from your income to lower your taxes (we’ll discuss taxes and deductions more in the next section).
  • You won’t have to ever worry about being told to move as long as you can afford the property taxes (and mortgage & insurance while the bank is loaning you the money to “own” it).
  • And of course, there’s the intangible but nonetheless meaningful pride of homeownership, long believed to be an integral part of The American Dream.

As with all important financial decisions, consider the pros and cons and decide if it’s the right choice for your circumstances. Just don’t automatically assume it’s always a better choice over renting.


Click here to read Part 4…

Index

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