Imagine that you are making more money than you have ever made in your life? What would you do?
First, identify where you are on this spectrum:
If you can account for what comes and goes out of your accounts, if you have paid off your debts, and saved up an emergency fund, then you are ready to begin investing.
Where to start in your investing journey
Start with fully-fund your retirement accounts. Depending on your employer you will have access to either a 401(k), for private employers, or for public employers you will have access to a 403(B) and possibly a 457(b). You can google, “401(k) contribution limits” to find out how much you can put into these accounts each year. In 2020, the contribution limits for each of these accounts are the following:
|Pre-Tax Account||Contribution Limit|
You fund 401(k)s, 403(b)s, and 457(b)s, with “pretax” dollars, meaning your contributions are taken from your paycheck before taxes are deducted. You will have to pay taxes eventually of course, but not until you retire (age 59.5 or older). The IRS taxes all withdrawals at your ordinary income tax rate at that point. BUT, when you retire, you will have little, to no income, so you will be taxed at a lower rate.
By fully funded your retirement accounts, you lower your taxable income, thus paying less in taxes. While I can’t tell you exactly how much you will save, you can learn more here: https://www.millionaireeducator.com/2019/11/tax-planning-2020-free-money.html
You can set this up with your HR person at your job.
Investing your money within your retirement plans:
Once you open your 401(k), or 403(b) and 457(b) retirement plans, your work is not done. Now you need to choose your investment vehicle within those plans. I choose to invest in index funds with low costs and low fees.
Why invest in index funds?
Warren Buffett, arguably the greatest investing mind known to humans, said this in a 2014 letter to his shareholders:
My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard‘s [time stock-symbol=VFINX].) I believe the trust’s long-term results from this policy will be superior to those attained by most investors—whether pension funds, institutions, or individuals—who employ high-fee managers.Warren Buffet, 2014
Why you should not pick individual stocks
Maybe you are thinking, “I am smart. I can pick winning stocks because I have made many good choices in my life.” History has shown that most people fail at the stock market because they try to pick winning stocks. No one can predict how individual stocks will do. A good example is the Domino’s verse Google story. Imagine that it is 2010. You are ready to start investing and you are presented with a choice between two stocks: Google or Domino’s Pizza. Where do you put your money?
Most people would say Google.
“However, in reality Domino’s share price growth has outperformed all of the world’s largest tech companies so far this decade. An investment in Domino’s at the start of 2010 has grown by more than 2,000% to date, leaving the likes of Amazon, Google, Facebook, and Apple in the dust.”
This is why index funds are the way to go.
What is an index fund?
In case you don’t fully understand what index funds are: a “stock index” is basically a list of big-name stocks for large, established companies (think Exxon-Mobil, Microsoft, Verizon, etc.) You take an average of all the stock prices in this list, and that gives you a number that’s kind of a thermometer for the stock market as a whole. When people say ‘the stock market is up today”, they usually mean that most or all of the popular stock indexes are up such as the S&P 500, the Nasdaq, and the Dow Jones.
An “index fund” is, in a basic sense, like paying a broker to buy all the stocks on a particular index (the S&P 500 is a popular choice). You send him $1000, and he splits is evenly between all the stocks on that index. This is an easy, low-cost way to follow the ups and downs of the market without having to make any decisions about which stocks to buy yourself. When one company fails in an index, it is replaced by another, better performing, income generating company.
The stock market has grown an average of 10% a year since its inception in 1926. Just by buying and holding index funds, you get to be part of this story and an average gain of 10% a year (as long as you don’t sell). You need to allow time to work its magic and for your money to compound.
The purpose of an index fund is to allow an investor a simple way to own some segment of the market in a predictable way that doesn’t require the investor to constantly adjust their positions. The index does that work for the investor, buying and selling whatever is in the basket according to the “rules” the index established when it was formed. Because the index is “rules based” and doesn’t have a human being in the loop making decisions, and thus doesn’t have to pay a manager an exorbitant fee to manage the index, the overhead costs of index funds are quite low compared to other kinds of investments.
How do I invest in an index fund?
First, you must open an account with a brokerage. I use Schwab, many people love Vanguard, and I have heard good things about Fidelity and T.Rowe Price. When choosing an index fund, you main concerns are consisent and steady growth over time and low fees.
PAY VERY CLOSE ATTENTION TO THE EXPENSE RATIO. To understand what a massive effect these will have on your money, use this calculator to compare expense ratios: https://www.bankrate.com/calculators/retirement/mutual-funds-fees-calculator.aspx
A fund like VTSAX, through Vanguard, has an expense ratio of .04%. If you are paying more than this, it could cost you a half-million dollars (or more) in lifetime earnings.
If you want to learn more, send me an email at: firstname.lastname@example.org or browse through more resources below:
- A 30 minute podcast that will explain index funds
- ChooseFI — all things early retirement
- Millionaire Educator — calculate how much you save by lowering your taxable income
- Expense ratio calculator
Personal finance websites geared to doctors: