FI Fundamentals

FI Fundamental #4: Invest What You Save

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Saving money is the first step to accumulating wealth, but to really accelerate your FI time horizon, you will need some help.

“Ok…help from what?”

Great question! And now for a great answer: EVERY PUBLICLY TRADED COMPANY IN AMERICA.

“Wow! Tell me more!”

Gladly! You see, when a company wants to finance and grow its operations, it either gets a loan (bond), or sells pieces of ownership (stock). Regular people like you and me can buy ownership of both stocks and bonds on an independent market exchange.

“So how does that help me retire early?”

I was getting to that. When you buy a company’s stock, you share in that company’s earnings. When the company does well, the value of the stock increases, and you make money.

“Won’t I also lose money when the company does poorly?”

Yep. But that’s why you don’t buy just one single stock. You want to diversify your holdings to improve your chances of success. If one company you own stock in loses money, at least you own stock in other companies that made money. In general, the more stocks you own in different industries, the more you decrease your risk of losing money.

“Yeah…there are a lot of companies out there. It seems kind of tedious to buy every single one…”

I agree! Luckily, you don’t have to pick each stock to own. You simply buy a mutual fund, which bundles together hundreds or thousands of stocks. When you own a mutual fund, you have tiny slivers of ownership in each of the companies in the fund. This makes it easy to invest in the stock market.

“So I can own every single stock available to the public?”

Yes-sirree-Bob! All you have to do is buy a total stock market index fund, like Vanguard’s VTSAX, and you’re set. Seriously. It’s that easy. You can buy only one mutual fund and benefit from the earnings of the entire U.S. stock market. Isn’t that great?

“Sure is! But what about bonds?”

For long term investing (like retirement), bonds are inferior to stocks. Even though the value of bonds do not fluctuate as violently as stocks, stocks greatly outperform bonds over long periods, so you will have more money in the end if you own 100% stocks. Many people still prefer to have some bonds to help smooth out the fluctuations, but you should understand that this is a completely emotional decision. If you want greater long term returns, only own stocks. (See Early Retirement Now for more.)

I’ll talk more about the specifics of why you only really need a total stock market index fund in the future, but for now, I’ll just focus on (very) general stock investing and how to do it. If you’re still itching for the specifics, check out The Simple Path to Wealth by Jim Collins and his stock series.

Aaaaaaand to avoid a lawsuit: I am by no means a financial planner or investment expert, so please do not take this article as investment advice. This is only meant to be a primer for those getting started in investing. Please do your own research and understand that you are responsible for your own decisions.

The power of compound interest

Let’s back it up and discuss why you even want to invest in stocks. Simply put: compound interest.

When the stock market increases in value, your investments increase in value. The awesome part is that the earnings are reinvested, so then your earnings are producing earnings. Now money that you didn’t even have in the first place is making you even more money. And you didn’t have to do anything more than set up an automatic contribution.

Example time!

compound interest

This graph compares the value of an annual contribution of $10,000 made at the beginning of each year.

The first line shows the value if you hadn’t invested (stashed under the mattress). After 30 years, you would have $300,000. Good, but not great.

The second line is if the money you put in each year earned 7% simple interest. You decide to take out the earnings each year, but leave all the annual $10,000 contributions invested. The first year you invest $10,000 and earn $700. The second year you put in another $10,000 for a total of $20,000 invested, so you earn $1,400, so your total money is the $700 you earned the first year plus the $1,400 you earned the second year plus the two contributions of $20,000 for a total of $22,100. After 30 years of this, you have $625,000. Not too shabby.

The third line is if you decide to reinvest your earnings (compound interest) like you would if you were investing in stocks. The first year you contribute $10,000 and make $700, but instead of taking it out, you leave it invested. After 30 years of reinvesting your earnings, you have just over $1 million.

Which scenario would you prefer?

“That’s a stupid question.”

Wow. That was rude…moving on…

Is investing just gambling?

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It might seem a little risky to trust all your money in the success (or demise) of some random companies. We’ve all heard the horror stories of people losing their life savings in market crashes.

As long as you aren’t trying to pick individual stocks, investing isn’t like playing the slots. There is intrinsic monetary value in the total stock market, and by owning a mutual fund like VTSAX, you set yourself up for success because you limit your risk.

Just remember the most important part of investing: don’t sell.

Weathering the storm

In reality, the stock market isn’t a nice continuous curve always going up like the example above. Sometimes it increases, and sometimes it decreases – a lot. It can be difficult to watch your net worth drop.

However, the value of your money isn’t real until you sell. Many people overreact when the market drops and sell at the bottom, and then miss out on gains when it rebounds. You might be tempted to try to sell right before you think it is going to drop, but the fact is that you never know when it is actually going to drop.

Study after study has shown that you can’t time the market. No matter how much you think you can, you can’t. Just don’t. Friends don’t let friends time the market. #ResistTiming #MarketStrong. Those will be trending in no time. Just you wait.

As early retirees, we don’t need to access a vast majority of our wealth at any one time. We are building wealth to so that we can make small withdrawals to support living expenses.

Because our time horizon is so long, we can weather the storms when they come. Don’t panic. Keep your money invested and stay patient. I know this is easier said than done.

Historically, the market has always gone up. Here’s my favorite chart of the stock market, thanks to Jack Damn.

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Each time the market experiences a “correction,” the most recent peak always seems like the highest it will ever get, and people lose faith in the market.

During the Great Recession, the Dow Jones Industrial Average lost over 50% of its value from the peak in October 2007 to the low point in March 2009. But in the approximately 10 years since the previous peak, the DJI has increased over 50% from the previous peak, and over 200% from the lowest point. From 2007 to 2009 it would have been difficult to trust that the market would rebound, but it wasn’t the first time the market had dropped so drastically.

Don’t listen to the doom and gloom television personalities. There is an entire industry about telling you how to invest, and they use fear to convince you that the stock market is an incredibly unstable, unreliable beast that will topple over at any minute. Quite consistently, the stock market increases at an average of 7% per year. Tune everything out and stay the course.

Remember: day-to-day fluctuations are mostly affected by people’s perception of the future value of the company, the long term gains are real and represent real value. Don’t be swayed by what is happening in the market today and remember that the market will always go up.

Where to invest

At this point, you know which fund to buy (VTSAX) and you know not to sell it until you need to use the money (retirement). So where do you put the investments?

In general, you have two options: taxable accounts or tax-sheltered accounts. The IRS taxes capital gains on investments, so you want to be smart about where you put your money to minimize taxes. There aren’t many rules for regular taxable accounts – they’re pretty straight forward. Tax-sheltered accounts are a little more complicated.

Tax-sheltered accounts

For the purpose of this article, tax-sheltered accounts are retirement accounts. The investments in these accounts grow tax free, and in some cases, your contributions are tax deferred and deductible, so you can pay less income tax during the year of contribution.

I’ll discuss each one (and others) in more depth in future articles, but here is a brief overview of the two most common retirement accounts available in the United States:

  • 401(k) – Accessible through your employer. In general, there is a maximum annual contribution of $18,000. Many employers offer a match (usually around 3% – 6% of your salary), so it is crucial to contribute up to that match if you have the option. Some 401(k) plans have high fees, so you might need to determine whether you money might be best placed elsewhere.
  • IRA (Individual Retirement Account) – Accessible to everyone with an income. In general, there is a maximum annual contribution of $5,500. You have the freedom to choose which company to use as the custodian for your IRA, such as Vanguard or Fidelity.

Other investment options

While the stock market remains the most accessible and reliable investment (if used correctly), there are plenty of other options to grow you money. Here’s a quick list:

  • Peer to peer (P2P) lending – this is still a relatively new concept. Investors act as lenders to borrowers who take out personal loans to pay off other debts. This is basically just bypassing banks and providing returns to average people, rather than institutions. However, the industry has not yet been submitted to a recession, so lenders should be wary about loan defaults during uncertain economic periods.
  • Real estate – Buildings and the land that they occupy carry intrinsic value simply because as population grows, land becomes scarcer. Investors can tap into the real estate market by purchasing land or buildings and then collect rent. The real estate market allows you to leverage (borrow large sums of money) your investment, so you can get started with a relatively small net worth.
  • Business – If you are willing to put in the time, effort, and take the risk, starting a business can be the most lucrative ways to grow your investments.

5 replies »

  1. Nice write up! How do you plan to invest for an early retirement? Will you put more in after tax due to availability vs. age/penalty/restrictions of pre-tax options?

    Like

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