Since I seem to be getting a reputation as a money geek, I shared details of my 2016 investment returns with a muggle friend and his eyes nearly popped out. How could it be, he spluttered, that he works hard and saves his money, yet I take the year off work and am still ‘rolling in dough’?! Well, I wrote him an email to explain…
In my opinion as a money geek, you are doing 2 things out of 3 perfectly.
1) You are maximizing your earnings (ie. you have a good job and are building a career)
2) You consistently spend less money than you earn
But the 3rd thing – which you are not doing – is the missing ingredient:
3) Optimize your investments! (Your money is rotting away in a savings account)
The problem is, all 3 of these go together like legs on a tripod: if you remove one leg, the whole rig collapses.
Show Me The Money!
As an example, let’s say you saved $10k and put it in a bank account. Nowadays a typical savings account will pay you about 1.5% a year. By comparison, the S&P 500 stock market returned around 12% in 2016. You could have instead put your money in a cheap ‘tracker fund’, which is basically a computer that buys shares in those S&P 500 companies to track its performance as closely as it can, so you would have made after fees approx 11.7%. So….you could have had after 1 year:
– Savings account: $150 interest (ie $10,150 total)
– Investment account: $1170 ‘interest’ (ie. $11,170 total)
What is the difference? There is risk in investment, since the stock market could crash: in 2007 your $10,000 would have collapsed to ~$6,000 by 2008. If you needed to spend it in 2008 it would be bad right? But if you left it in there, the $6,000 in 2008 would be ~$18,000 today!
But, there is also risk in your savings account. The risk is from inflation. Let’s look at the same period: from 2007 – 2016, if you had $10k back in 2007 you would have earned 10 years interest at 1.5% a year, meaning your account would now have $11,605 in it. But $10k back then is not the same as $10k today. Due to inflation, your $10k back then is equivalent to $12,600 today. (If you think about it it makes sense: 100 years ago $10k was a huge amount of money right?).
So, your savings account has actually lost you money! You have $11,605 on your $12,600 investment. Meanwhile in the investment account your $12,600 would be $18,000. So which is riskier? Up to you, but I know what is riskier for me!
Get in the Right Mindset
The thing you need to do however, is to get the mindset that you have to put your money away for a long time. Think 10 years as an absolute minimum. I like to think about 30 years. Then you can benefit from compounding ( ie. interest earns interest earns interest etc…growing your money exponentially).
My idea is not to get ‘rich’ or reach a certain target. Rather, my idea is to save enough money such that my money will earn enough to replace my salary and/or pension for the rest of my life….at that point I can say I have reached ‘financial independence’. Of course, if you save some money and start to look at fancy cars or bigger houses…you will need to save for a lot longer!
What Are You Waiting For?
Anyway, my advice is just get started and invest. The later you do it, the more you will regret not having done it earlier. Put a small amount each month into your investment account, through the good times and the bad. Invest in low-cost ‘tracker’ funds, which are well-diversified and so lower risk. You can try to pick funds that are managed by real people, but these are much more expensive and the sad fact is most of them fail to consistently beat the market average, so all you are doing is taking on more risk, making the fund manager wealthy, and giving yourself less returns.
You can open a very low cost account – I suggest with Fidelity ($2500 minimum initial investment) but check out this review from the guys over at review.com – and invest as little as you like. Can you save $50/month?
What Do I Invest In?
- Buy low-cost index tracker funds
- 3-5 funds is plenty
- I recommend Vanguard funds
- My personal preference is 35% US-based, 25% developed world (Europe, Japan etc), 20% emerging markets, and 20% government bonds
If you are wondering what government bonds are, they are simply another way to invest. Where stocks are small pieces of companies, bonds are loans to companies or governments on which you are paid annual interest. Government bonds are particularly safe as there is virtually no risk – if the government were to run low on funds it could simply print more money.
The “Bogleheads” (Jack Bogle superfans) will keep you right – Start here!
Lots of love,
A money geek