Investing 101 — Save, Invest, Repeat (Part 2/2)

This is Part 2 of a two-part series on how you can start investing. If you have not already, read Part 1 first.

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I understand the topic of personal finance is not exciting. Especially an article on saving and investing for the future, when you can spend the money now. But, want to know what’s less exciting? Not having enough to retire. Ask anyone in their 60’s putting in 8-hour days out of necessity and they will urge you to start now. And how they wished they had made smarter financial decisions. Don’t take your future self for granted. Take the necessary steps today — no matter how small they may feel — to set yourself up.

You do not have to make a lot of money in your life to retire well. Don’t get me wrong, it definitely helps, but it is not the end all be all. In fact, millionaires are disproportionately clustered in middle-class and blue collar neighborhoods and not in more white-collar communities (“The Millionaire Next Door”). Such individuals lived within their means, making it a priority to save and invest.

Anyone can follow the “millionaire next-door” mentality; however, you need to know what to invest in and how. We started answering these daunting questions in the first part of this article. Let’s now proceed to the second and final part, after which you will be equipped with the knowledge to start investing today!

Other Investment Options

There are many types of investments available to you besides the stock investments we discussed in Part 1. The goal is to keep things simple, so we will focus on only two options.

Bonds

Bonds are a fixed income investment where the investor loans money to an entity, which borrows the funds for a defined period of time at some interest rate. It is an IOU — I will give you ‘$x’, which you pay me back in ‘y’ years, while paying me regular interest payments of ‘$z’

There are many entities investors can loan money to. However, our focus will be on bonds involving the US government. Why? Because payments are essentially guarenteed. If you lend $1,000 to a friend, the only way you receive timely payments is if he or she has the money. If Uncle Sam doesn’t have the money, he simply prints more OR borrows from somewhere to pay you back.

U.S government bonds come in various flavors — different maturity dates (the time after which the full loaned amount is to be re-paid), interest rates, payment schedule, etc. Thankfully, you don’t need to keep track of this.

Similar to index funds tracking the S&P500, there are index funds replicating the U.S bond market as a whole, with a majority focus on U.S government bonds. Therefore, you can lend money to Uncle Sam without any of the associated confusion that comes with buying and selling individual bonds.

Cash

You never know when you need access to quick cash. You probably have a checking account for normal day-to-day spending, as well as a savings account paying you interest on money you set aside. For the purpose of this article, “cash” is simply the amount in your savings account you can transfer to your checking account if needed.

Not all savings accounts are the same. In particular, banks with no physical branches provide much higher interest rates. In other words, you don’t have the luxury of walking into the bank, but you do earn more interest money each month. This trade-off is worth it, since you can transfer money in and out of your savings account electronically anyways.

At times, you may need more cash (for an absolutely urgent expense) than what is available in your savings account. If so, you can sell part of your stock and bond investments. However, treat this as the last resort. The goal is to leave your investments alone, allowing compound interest to let them grow.

Final Investment Principles

Now that we have discussed the options you need to concern yourself with, I want to outline some basic investing principles. Take time to internalize these, as they are the catalyst behind all successful plans.

Diversification

To diversify means to not put all your eggs in one basket. No matter how confident you are with a particular investment, there is always the chance of an unforeseen event resulting in losses. Therefore, it is important to spread your wealth into various assets.

With my plan (which I will share later), you will invest across 500 stocks, various types of bonds, and cash. If one asset class drops, the other two serve as buffers to neutralize your portfolio.

Risk vs. Return + LONG-TERM Focus

All investments have some level of associated risk. With stocks, the economy can enter a recession, causing prices to decline. With bonds, the borrower may be unable to make the necessary payments on time.

Stocks are assumed to be riskier than bonds. To compensate, riskier investments are usually paired with higher returns; hence, stocks, OVER LONG PERIODS, generally return more than bonds. It is super important to understand this. In the short term, there will be a lot of fluctuation in the stock market, but over a period of 20–40 years, the short term fluctuations smooth out and reveal steadily increasing returns.

See the image below. Notice the short-term period between 1970–1980 and 2000-2010. The price at the end of each decade was at about the same level as the beginning (despite drastic upward and downward fluctuations). However, over a longer period of 65 years outlined by the graph, the growth is quite obvious.

Dollar-cost averaging

Dollar-cost averaging takes advantage of such short-term fluctuations in both stock and bond prices. I am sure you have heard “buy low, sell high.” Trust me, easier said than done. Think of investing as a game of accumulating assets, rather than a game of timing the market. Your goal should be to buy more when prices are low and less when prices are high.

With dollar-cost averaging, you are investing a set amount over fixed intervals, independent of the price of the asset. For example, say you allocate $100 each month into some S&P500 index fund. The current price of the fund is $100, affording you 1 share. Fast forward to the next month. The price drops to $50. With the same $100, you now purchase 2 shares. You are naturally taking advantage of low prices by scooping up more assets.

See the image below to prove the effectiveness of this concept. The green line represents $1,000 invested over 128 monthly payments of $7.81; the gray line represents a one-time investment of $1,000. Track both lines till the end date — notice the green line out-gains the gray line by about $250. Might not seem like much, but given the original investment, that is a 25% additional growth!

Sample Investment Portfolio

What should I buy

Your portfolio should contain some combination of stocks, bonds, and cash. Here is what I recommend for young adults:

• 70% low-cost S&P500 index fund (Stock)
• 17.5% low-cost U.S bond index fund (Bond)
• 12.5% cash in a high yield savings account (Cash)

Your portfolio is stock-heavy, because of the superior returns over the LONG TERM. However, you still need some diversification with the more stable bonds, as well as cash you can tap into as needed.

How should I buy

Say you earn $3,000/month after taxes, which is deposited in your checking account. You “pay yourself” $600 (20% of $3,000) up front, by doing the following:

Step 1: Set up a monthly automatic transfer of $75 from your checking to savings account. This takes care of the 12.5% in “cash”

Step 2: Set up a monthly automatic transfer of $525 ($600 minus $75) from your checkings to your brokerage account where you will purchase your stock and bond index funds.

Step 3: Set up an automation inside your brokerage account to invest $420 into the S&P500 index fund (70% of $600) and $105 (17.5% of $600) into the U.S bond index fund each month.

Make sure that you set all automation dates to the beginning of each month. For example, if you get paid on the 2nd, set the transfers to your savings and brokerage accounts for the 5th. Inside your brokerage account, set the date for the 10th to purchase the investments.

And that’s it. You accumulate assets each month, and not have to worry about daily prices and the general economic conditions.

Annual Rebalancing

At the end of each year, you need to re-balance your investments. Following the example from above, you have been investing $420 in S&P index fund, $105 in U.S bond index fund, and $75 in cash each month.

Say, at the end of the year, this is how much you have in each asset:

• S&P500 index fund → $9,000 (75% of total)
• U.S bond fund → $2,000 (16.7% of total)
• Cash → $1,000 (8.3% of total)

As you can see, the ratios are no longer 70–20–10 because stocks increased in value more rapidly than bonds and cash. In order to re-balance your portfolio, you would manually sell some of your S&P500 index fund to buy more bond funds and replenish cash supplies.

Re-balancing might seem counter-intuitive, since you are selling the asset that’s earning the most money. However, realize that past growth doesn’t mean future growth (in the near term). In fact, it’s quite the opposite — what goes up must come down at some point. And when it goes down, you want the additional funds in your other assets to re-allocate back into the current winner. Look at this as another way that naturally addresses the principle of “buying low and selling high.”

Cater your investment ratios to your needs/situation

No two people are in the same situation — you might be between jobs or have outstanding debt you are paying off. Therefore, the plan I outlined above can and should be tailored to your needs. Here are several situations that may suit you better:

• You can save 30% each month instead of the 20% minimum I recommend. If so, excellent! You accelerate your road to financial independence by utilizing more savings to “work for you.”
• You can only save 5-10% each month. Not a problem — the key thing is to just get started. In this case, I would do a 50–50 split between the S&P500 and cash.
• You are in your early 20s and want to earn the maximum potential returns. If so, invest a larger percentage into the S&P500 index fund, at the expense of bond funds. An example split could be 80% stocks and 20% cash. Make sure you have enough cash, so you can leave your stocks alone for a while.
• You want to save money for a trip/house in the future. Invest the original 70% in stocks and the rest in cash.
• Your brokerage account only lets you purchase funds in multiples of $50, with a minimum spend of $100. In this case, approximate the specific dollar amount you can invest each month. For example, if 70% of your income comes out to $148, invest $150.
• You have been investing for a couple years and have enough cash to neutralize any big expenses you may incur. In this case, dedicate your savings solely towards buying index funds (or even a bit into individual stocks if you are up for it).

The key thing to start now and be consistent with a strategy that suits you best. It doesn’t matter if you are investing $100 or $1,000 each month, just do it and stick to it. Remember to utilize the automatic transfers so you can forget you are even investing. Like a good chef, let the food cook itself.

However, don’t be afraid to change your plan every 5–10 years. If you are in your 20s, dedicate a larger share to stocks. As you get older and closer to retirement, focus more on stable options like bonds. Or, if you spend time reading and understanding annual 10-k reports (here is sample report for Apple), throw a few percentage points into individual stocks if you are up for it.

A Final Word + Recommendations

Investing is not hard. All that is required is some initial automation setup and an absolute imperative to stick to your plan.

What I have outlined here is not a sexy, “get rich quick” scheme. Your money will not double overnight. Actually it’s quite the opposite, it may take decades for growth to materialize. But, your money is safe. The risk of a complete loss is extremely low. At the end of the day, that is what true investing is about — a “margin of safety” ensuring your money will be there when you need it in the future.

To end, here are my personal recommendations on savings account and index funds:

• Savings account — Goldman Sachs Marcus®. Offers some of the best interest rates in the industry.
• Brokerage account — Charles Schwab®
• S&P500 index fund — Schwab® S&P 500 Index Fund (SWPPX.) The lowest fees and stock turnover (how often they sell stocks in a year — meaning less taxes) in the industry
• U.S Bond index fund — Schwab® U.S. Aggregate Bond Index Fund (SWAGX). Low fees with most of the fund’s assets in government securities.

Happy investing!

Note: I have no monetary connection with any institutions and/or investment product mentioned above. They are merely what I recommend based on countless hours of research, as well as my own personal use.