This post is designed to serve as a reference point for our basic philosophy of saving, investing, and growing your wealth so that you can have a comfortable life and retirement. Stick to these basic tenets of growing your wealth and you will be guaranteed to come out ahead.
- Come up with a plan and stick to it. This can be as simple or complex as you want it to be, but should include a set of basic goals and how you plan to invest to reach those goals. You give yourself a set of rules to save and spend by. Putting it down in writing makes it concrete and helps you stick to your guns when you’re tempted to stray from your plan. Think of this as your constitution, which you can refer to when you need to figure out how to act in a given situation: a financial windfall, a home purchase, or a bear market. Like the Constitution, your plan can and should be thoughtfully amended over time. The gold standard is the investment policy statement (IPS), which is a detailed document specifying detailed financial goals, desired asset allocation and how it should change over time, manner and frequency of rebalancing to maintain that asset allocation, types of investments to allocate to, etc. It’s okay if your first iteration of this is a simpler basic investment plan that you grow into a full IPS; the important thing is to get something down in writing to make you stick to a plan.
- Start investing now and keep investing regularly. It’s hard to understate the power of invested money to grow over time. Albert Einstein called this “the eighth wonder of the world.” The longer you delay saving meaningful amounts of money, the longer it will take you to retire or reach your goals, and the lesser your eventual wealth will be. The more of your income you can wall off for savings, the faster it will start growing. A good benchmark is at least 20% of your income. The raw material of any wealth accumulation plan is brute force savings, which is sculpted by investing in an efficient market into a work of art that generates additional returns on the initial investment and builds additional wealth. There’s no magic trick of investment or finance that creates wealth out of nothing – you have to put something substantial in before it can meaningfully grow!
- Spend less than you earn. Did you blink at “20% of your income” above and think you couldn’t possibly afford to put that much aside? It’s time to take a hard look at your spending and figure out how to make that happen. You’re spending your future retirement money right now. Everyone has their stories. We all have extenuating circumstances or financial hardships, but a huge chunk of the money we pay out every month is a choice. You should consider 20% of your income to be a minimum goal for how much of your income to save and constantly strive to increase it. If your goals include early retirement, that number should be closer to 50%. You should think of saving as absolutely mandatory, like taxes. However, unlike taxes, saving is not externally enforced, which means that it is easy prey for all the psychological features our brain has evolved to ensure short-term survival/reward at the cost of long-term planning. Just start saving. Automate your contributions, do everything you can to take psychological weakness (opportunities to not stick to your plan) out of the equation, and make savings as ironclad a requirement as taxes are. An obvious corollary to this rule of spending less than you earn is to minimize debt and its attendant interest rates, especially bad/delinquent debt and high-interest debt.
- Keep costs and taxes low. Costs matter in investing. Look at the expense ratios (ER) for your mutual funds. You can subtract that from your earnings – a 4% return on your investment becomes 2.5% if your mutual fund has a 1.5% ER – an almost 40% haircut on your earnings (by the way, if 4% return on equities sounds way too low, some very smart people think this might be a new norm for a while after the current rally ends). Taxes on your earnings represent another force of drag on your growth. You’re under no obligation to arrange your investments to expose them to the maximum possible tax burden. Even the government thinks you should be able to shield your retirement savings from taxes – that’s what tax-advantaged accounts like 401(k)/403(b), traditional IRAs, and the Roth versions of those accounts are for. Take advantage of those and preferentially put investments that are likely to cause increased tax liability (for example, through dividends or capital gains distributions) in those accounts. Choose tax-efficient investments like low-cost total market index funds that deliberately buy and hold without generating lots of capital gains distributions from selling stocks.
- Diversify. Even more important than where you put your funds to minimize taxes is which funds you buy in the first place, and in which categories of investments (i.e. your asset allocation). The trick is to harness the maximum possible returns from the market while lowering your risk of loss as much as possible. That’s the magic formula that no one has ever reliably, consistently cracked, despite all the talking heads and investment gurus claiming so on a daily basis. But one universal truth in investing is that spreading your investments out among different sectors of the economy and different types of financial instruments is a way to lower your exposure to the risk of any one of those things. The most thorough way to diversify is through broad index funds that own parts of most of the companies in the stock market, and parts of most of the bonds in the bond market. The ratio of stocks to bonds is generally the most important part of the asset allocation, and a rough measure of how much risk you are assuming (in general, stocks have higher potential returns with higher potential risk of loss, and bonds are more stable and less risky but with lower returns). There’s no mathematically right answer to this decision and your asset allocation should allow you to meet your investment goals while mitigating risk enough (e.g. with bonds) to let you sleep at night.
- Keep it simple. If you’re just starting out in investing, the sheer number of choices and combinations of investments can be bewildering. Many professionals (both financial professionals and otherwise) put so much time and effort into buying, selling, timing the market, and finding the perfect combination of mutual funds or individual stocks that are destined to explode. It can seem like a full-time job to keep up with a big, complicated portfolio of investments. But here’s the secret: All that extra effort is wasted and results in returns that are, on average, almost always lower than the overall market. You don’t need to own a zillion funds to have an excellent, diversified sample of the entire market – that’s what broadly-diversified, low-cost index funds are for. You can own pretty much the entire market – and reap all its returns – with the elegant and simple three fund portfolio, one example of simplicity at its finest. As simple and “lazy” as that investment strategy seems, it’s very hard to beat, in part because it’s so well diversified and low cost. A simple investment plan is harder to screw up, easier to stick to, and minimizes cost and taxes.
- Stay the course. One of my main principles of personal finance and investing is that your worst enemy is yourself – or more precisely, that primitive caveman brain part of yourself that acts on impulse. Your brain is highly evolved to subconsciously recognize patterns (even when most patterns are relatively meaningless on the random walk down Wall Street) and quickly act in response to both fearful and rewarding situations. Emotion and impulse are your enemy in investing! You have to design ways to defeat this primitive, responsive brain that uses neural pathways that were helpful to the survival of our caveman ancestors, but which result in you making an impulse purchase or fear-selling your stocks in a correction or bear market. Give your advanced, rational, executive brain every advantage over your primitive brain by eliminating chances for that devil on your shoulder to do something you’ll regret later:
- Enforce your savings by automating your contributions.
- Make a plan that you can refer to as a guide when you’re thinking about making a big purchase or change in how you invest your savings (see principle #1).
- Keep relentlessly investing sensibly according to all the above principles and don’t deviate from your master plan (even – no, especially – in times of financial hardship or the inevitable market downturn)
Will these principles provide you the guaranteed shortcut to getting fabulously rich? No! Nothing will! But they will give you the best shot at maximizing your wealth and fulfilling the goals you set for yourself.
What do you think? Do you have a master plan that you’ve enacted? Is it different from ours? Do you disagree with buy-and-hold index fund investing, or prefer a more “sophisticated” approach?