There are many different ways to invest. While I follow the index fund approach, focusing on saving as much as possible, and generally letting the market do its work, I’m often caught up in conversations with people that claim to have a “better” approach. Often they’re hot off a recent good run (i.e. Facebook, Netflix, etc.) and are starting to feel confident about their ability to pick the winners. I think there’s nothing worse than having some stock picking success early in your career. It can set you up for a decade of poor performance. But regardless of whether you choose to invest exactly as I do (and naturally almost nobody will invest exactly like me), there are a few guidelines that I think apply to all investors.
1. Setting The Right Goals
You’ve heard it before, but a ship without a destination cannot make it into port. Far too many investors simply try to “save as much as possible” without setting any actionable goals. Those investors will quickly fall behind since they’ve set an unachievable goal (i.e. what’s “as much as possible”?) with no way to measure the results. Without a goal, it’s impossible to set up a financial plan.
As a lawyer, we’re trained to see risk everywhere. There’s no such thing as a perfect contract or an airtight case. Perhaps for that reason, I don’t really like to leave my investing goals undefined. I’d rather set something actionable and then achieve it. This isn’t as hard as it sounds and can always be changed. It’s just better to start by saying that you’re going to save $X a month rather than leaving it to chance.
2. Taking The Right Amount of Risk
Investors are trained to think that the higher the risk, the greater return. Unfortunately, that’s simply not true. The higher the risk, the greater the expected return. Otherwise, you could simply make a pile of money betting on black at the roulette table.
At the same time, if you fail to take on any risk your money will be lose its purchasing power. Keeping everything in cash is a losing proposition.
Many investors are constantly moving back and forth between no risk and too much risk. Worse, sometimes an investor will take on unnecessary risk by betting on a single stock or unintentionally over-leveraging their investments. So you have to thread the needle between taking on too much or too little risk.
This is accomplished by selecting a reasonable asset allocation that makes sense to you. To come up with a number, you can take an online quiz or do a little reading about asset allocation.
3. An Adequate Savings Rate
It won’t help to have a solid plan and an appropriate amount of risk unless you’re saving enough money. Often investors get caught up chasing a rate of return, as if the difference between 7% or 8% matters if you only have $10,000 in the bank. The facts are pretty clear that during the accumulation phase of your career, your savings rate is much more important than your rate of return. If you’re looking for the most bang for your buck, simply figuring out how to save more money will have a greater difference to your bottom line thank even worrying about your rate of return.
How do you figure out how much to save?
Unfortunately, lawyers start investing and saving later in their careers which means that a 5% or 10% savings rate isn’t going to cut it unless you plan on working until you’re in your 70s.
If increasing your savings rate is problematic, most investors would do well to establish a baseline savings rate today which can be improved in the future. Your income will likely increase over time and if you fix your expenses and savings rate today, all future raises and bonuses can be added to savings. You may also find that as time goes on you can make small changes to boost your savings rate.
4. Getting Started Now
The best time to get started investing was 10 years ago. The second best time is right now.
Those that start saving earlier in their careers will do remarkably better than those that put it off for 5 or 10 years (some lawyers don’t start even thinking about saving until they’re in their late 40s).
Ironically, getting started when you’re young is the hardest time to do it. At the beginning of your career, there are a lot of competing demands for your dollars. Because those dollars are being pulled and pushed in so many directions, it’s all the more important to sit down and think about what will have the greatest long term benefit for each dollar.
When I first maxed out my 401(k) account, it felt like a big thing. That’s more than ten thousands after-tax dollars I didn’t get to see. But you quickly forget about it and it becomes second nature after a couple of years. I can’t imagine not contributing the maximum amount every year going forward. From my anecdotal read of the financial blogosphere literature, pretty much everyone else feels the same. There’s a sting at first but you’ll adjust pretty quickly once it becomes the default option. Get started today.
5. Owning The Whole Market
In the 1970s Jack Bogle had a great idea. Why try to find the needle in the haystack and when you can buy the whole haystack?
His company, Vanguard, started offering index funds with few believers and a lot of skeptics. Most money mangers were convinced that they could outperform the market. And while there are a few amazing money managers out there, it’s pretty silly for the average lawyer investor to think he or she can play in that league.
Best of all, when you own the entire market, you don’t spend any mental energy worrying about particular sectors or individual stocks. It allows you to turn off the craziness that is Wall Street and Mr. Market. As long as the United States economy continues to produce goods and services, you’ll keep the lion share of those returns. Don’t fool yourself into thinking that you need to make a smart bet. It’s an unnecessary risk that more often than not will work out poorly for the person taking the bet.
6. Pay Attention to Fees
If you’re invested in a mutual fund, a 1% fee may not seem like a big deal. On the other hand, if someone told you that they wanted to take 25% of your return you might be more likely to perk up your ears and pay attention. Taking nearly a quarter of your investment return sounds like a pretty big deal.
Yet, a 1% fee may very well be equal to 25% of your investment return.
If we assume that the market will return a steady 7% over the coming decades, we may be quite happy with such performance. If 3% of that is eaten away by inflation, that’ll leave a 4% real return for the investor. A 4% return real return may not sound like much but it’s plenty to allow your money to grow by leaps and bounds.
Yet, if you take that 4% return and give away a full 1% to someone in investment fees, you’ll be handing away 25% of your actual returns (your investment manager doesn’t care about inflation, they’ll just take a portion of your return and move on with their business).
Suddenly the 1% fee seems downright depressing. If you take the time to look at your fees, you’ll find that you can likely replace whatever your currently invested in with a low cost option. The lowest index funds charge as little as 0.04% per year. That’s the difference between giving someone 25% of your investment returns and giving them 1%. It’s not hard to understand that the investor who decides to keep 24% of the return for himself will outperform the investor that is obliviously paying 25% to an investment manager.
7. Wherever Possible, Reduce Taxes
I’m in favor of paying taxes. I like the government and think that it needs to be funded and that it’s my civic responsibility to do so. But wealthy people understand the tax rules and they use them to their advantage.
It turns out that taxes are simply a matter of calculating your fair share and then moving along in life. The government uses the tax code to shape all types of economic and social policy by incentivizing you to take certain actions that they want you to take.
You can either fight these incentives and simply do as you please (and pay more taxes) or you can take the government up on its offer and adjust your behavior accordingly. I’m of the view that you shouldn’t fight the government, particularly when doing so will make you poorer.
Once you have a good investment game going (again, your savings rate is more important than reducing your tax burden), the next obvious step is to continue your financial education when it comes to learning the ins and outs of the tax code.
For me, this means taking advantage of every pre-tax account I have (whether it’s via myself or my spouse). If the government is going to incentivize saving for retirement, I’ll be right there doing exactly what they want and taking my tax break along the way.
8. Consistency, Consistency, Consistency
Once you have the system set up and have a basic understanding of finances, the final thing you need is simply time and consistency.
In some ways, this section could easily be laid out as things that you shouldn’t be doing:
- Don’t check the market daily (it doesn’t matter).
- Don’t change your investing plan (save more money if you feel like you’re behind).
- Don’t divert savings for a one-off purchase (you know as well as I do that it’s not a one-off purchase but simply a failure to budget).
- Don’t lose sight of your goals (write them down!).
- Don’t worry about your money (set it and forget it).
As I said in the beginning of the article, it really doesn’t matter to me how you invest and what decisions you make. I don’t get an extra boost to my return if you invest the same way I do. What’s important is that you figure out a plan, set goals and then meet them. If that happens because you bet it all on Facebook, I’ll be there to congratulate you along the way. Just make sure you keep good notes on your investment choices!
Let’s talk about it. Did I forget anything? If you were to add a #9 and #10 to this list, what would it be?