Achieve Financial Independence with Wise Investing: Keep it Simple and Low Cost
The goal of this article is to provide a primer on investing in low cost index funds. A simple low cost portfolio of stocks and bonds, along with a high savings rate, has been my very successful vehicle of choice toward financial independence (FI). Investing in stocks and bonds doesn’t need to be complicated and, in my opinion, a simple portfolio is wise portfolio. There is a certain element of risk involved, but don’t fret, for without risk there is no reward. As you will see, you can significantly reduce your risks by being well diversified with only a few funds. Let’s get started.
Invest in Tax Advantaged Investment Vehicles
Tax advantaged investments typically refer to 401(k)/403(b) or a Roth IRA.
401(k) and 403(b)
401(k) and 403(b) are company sponsored retirement plans, with 401(k) being provided by for profit companies and 403(b) provided by tax exempt organizations. If your employer offers one, take advantage of it.
All income invested in these plans is deducted from your paycheck before it is taxed. That’s right, investing in these plans means less of your hard earned cash is being taxed. Depending on your tax bracket, this can add up to some nice savings. Investing in a 401(k) or 403(b) provides a double advantage as it lowers your taxable income, thereby freeing up more money for investing! It also grows tax free until you are ready to access it. The annual contribution limit for these plans is currently $18,000. If your employer offers a company match, BONUS! It’s like free money, don’t pass it up.
If you don’t have access to company sponsored retirement plans, or you have maxed out your 401(k)/403(b), then look into a Roth IRA. Unlike a 401(k)/403(b), a Roth IRA does not lower your current taxable income. However, it provides tax advantages by allowing your money to grow tax free. It also allows your money to be withdrawn tax free when you eventually need it.
The current contribution limit into a Roth IRA is $5,500 a year. There are also eligibility limits. If you are married and filing jointly, your adjusted gross income (AGI) must be lower than $194,000. If you are single, your AGI must be lower than $132,000. Other rules do apply. You can get the full scoop here: IRS: Roth IRA’s
To have access to a Roth IRA, you will need to open a brokerage account. I recommend Vanguard due to their low fees. Vanguard: How to Open an IRA. An account is simple to start and you can call the helpful people at Vanguard if you need assistance.
If your employer doesn’t offer a retirement plan or you are fortunate enough to max out all of the tax advantaged options mentioned previously, you will need to open a taxable brokerage account. We will save the details on this for a future article.
Assess your Risk Tolerance and Develop your Asset Allocation
Asset allocation generally refers to the percentage of equities vs. bonds in your portfolio. This is a very simplified explanation but, remember, the goal here is to keep it simple. Equities (stocks) are viewed as more risky and volatile, while bonds are viewed as more stable and less risky (although they are not without their risks). The more risk (equities) in your portfolio, the higher the potential reward. However, you also run the risk of losing more in a down market.
What is your Risk Tolerance?
You need to identify and consider your own tolerance for risk when considering your asset allocation. If the stock market were to drop 50% tomorrow, would you be able to shrug it off and keep your cool? Would you panic and sell? Ideally, you want to develop a ratio that will keep you sleeping at night if the market takes a turn for the worst.
Keep in mind that you don’t lose money in the stock market until you sell. Most investors who lose money in the stock market do so because they allow emotions to guide them. They panic and sell when the market is down and then wait until it recovers to get back in. In effect, they are selling low and buying high, which is a sure way to lose money. So, be honest with yourself and select an asset allocation that will keep you from making emotional decisions and allow you ride out the bad times.
What is your Time Horizon?
Your time horizon, or how far from retirement you are, also needs to be considered. The longer your time horizon, the more time your portfolio has to recover from a down market. As a result, if you have a long time horizon, you should be taking more risk and maintain a larger percentage of equities in your portfolio. If you are close to retirement, you may want to consider being less aggressive and maintain a larger percentage of bonds.
A simple rule of thumb, as suggested by John Bogle and the Bogleheads, is to maintain your age in bonds: Bogleheads Wiki: Asset Allocation. For example, if you are 25 years old, your portfolio would hold 75% in equities and 25% in bonds. I feel this is a good starting point. However, I have a high risk tolerance and feel it is a bit too conservative for my own portfolio. As a result, I hold a much larger percentage of equities. In addition, as I approach financial independence, I have much more flexibility regarding when I “retire”. I can choose to work several years longer to ride out a down market before I officially retire and start to draw down my retirement funds.
Invest in Low Cost Index Funds
What are index funds? Unlike actively managed funds, index funds do not have managers picking and choosing their investments. Index funds simply follow a particular market benchmark, such as the S&P 500, which is a listing of the 500 largest publicly held U.S. companies. In addition, some index funds are a roster of the entire U.S. stock market or a roster of the international stock market.
Investing in index funds has several advantages:
- Lower costs. These funds are not actively managed by fund managers. As a result, they generally have much lower fees, saving you money. A savings of 1% may not seem like much. However, over the life of a portfolio it can add up to hundreds of thousands of dollars.
- Lower risk through diversification. Many index funds hold hundreds or even thousands of stocks or bonds, making them naturally diversified. Diversification lowers your risks by reducing the impact of any individual low performing stocks.
- Simplicity. Index investing enables you to hold a portfolio of only a few funds while maintaining diversification. This allows you to easily manage your portfolio without an advisor, thereby saving more on fees.
Depending on your situation, keeping things simple may be easier said than done. For example, I am currently managing my 401(k), my wife’s 401(k), two Roth IRA’s, several other IRA’s, and a taxable account. Unfortunately, our employers do not offer our Vanguard funds of choice. They do, however, offer relatively low cost S&P 500 and bond funds. As a result, our current portfolio consists of eight funds, which is still very manageable.
Eventually, I would like to reduce this to only three or four funds. When we leave our employers, we will roll over our 401(k) accounts into Vanguard IRA’s and simplify even further. Eventually, we will have something that resembles the Bogleheads three fund portfolio: Bogleheads: Three Fund Portfolio
Pay Close Attention to Expenses
When exploring your available fund options, pay close attention to the expense ratios. Generally speaking, the expense ratio is what it will cost you to hold the fund. As mentioned previously, expenses can have a large impact on your portfolio performance over time. Expense ratios can run anywhere from .04% to well over 1.5%. This information should be readily available on your employer’s 401(k) or 403(b) website.
You can also find the expense ratio of any fund on the Morningstar website: Morningstar. Just type the ticker symbol of any fund in the search area and take a look at the “expenses”. For example, if you do a search for VTSAX, you will see expenses of 0.04%, which is very low. Remember, the goal here is to choose well diversified index funds with low expense ratios.
Stay the Course
Once you have developed an asset allocation that you are comfortable with, maintain that asset allocation by rebalancing once a year. Choose any day of the year, your birthday for example, as your rebalancing date. Rebalance if you are out of whack by 2% or more. Rebalancing should be pretty painless if you developed a simple portfolio of a few index funds.
Avoid the temptation to time the market, as this is typically a losing proposition. This should be fairly easy if you appropriately assessed your risk tolerance when developing your portfolio. Maintain your asset allocation and be patient while the magic of compounding interest works for you. The rewards will be great.
If you need further assistance with choosing your funds and asset allocation, you may find the following resources helpful:
Paul Merriman offers an nice guide to fund selection for several 401(k) custodians including Vanguard, Fidelity, and T Rowe Price: Paul Merriman: Mutual Funds
Bogleheads. An excellent resource for assistance with asset allocation, especially if you are combining several portfolios, is the Bogleheads forum. There are several well informed and experienced investors on this forum that are willing to lend a helping hand. If you do decide to use the bogleheads as a resource, please follow the posting format as outlined here: Bogleheads: Help with Portfolios – Posting Guidelines
Although it will require a bit of your time up front, following the posting guidelines will provide the Bogleheads with the information they need to assess your situation thoroughly and provide you with the best course of action. This process is also very helpful in educating yourself regarding your investment portfolio and investing in general.
Jim Collins Stock Series. I highly recommend you give this a read. Jim has a knack for putting together an easy to understand and enjoyable read regarding simple investing. I recommend it to everyone who asks: Jim Collins: Stock Series
Investopedia. Have you come across investing terms you don’t understand? Just do a search here: Investopedia
As you can see, investing in stocks and bonds does not need to be complicated. Hopefully, this article has encouraged you to start and maintain a portfolio of simple, low cost, well diversified index funds. Don’t hesitate. Start investing as soon as you can to get the power of compounding interest working for you. Once you get your hard earned cash working for you, please remember to continue that education process. Knowledge is power and integral to achieving FI.
Disclaimer. I am not a financial advisor. I am simply sharing my own philosophy on investing, which has been very successful for me. However, past performance of the stock market is not a predictor of future performance. With investing comes risk and you need to understand those risks before proceeding. If you do not wish to do the work of educating yourself regarding investing then, by all means, seek the advice of a financial advisor.