There’s a lot of conflicting information out there on how to invest your money.
But there’s also a ton of reliable information outlined in books like The Intelligent Investor, The Simple Path to Wealth, and Your Money or Your Life.
The common theme of these books is that index investing is the guaranteed, reliable way to invest and profit in the stock market in the long run.
Investing when you are young is the best gift you can give to your future self. Money put away in your 20s will compound and double multiple times over your lifetime, if left untouched.
So how do we accomplish this magical doubling of our money over time?
For reference, let’s start with what you shouldn’t do.
Don’t Let Someone Else Manage Your Money
You should not give your money to a financial advisor or investment management firm to manage your money for you.
There are a few exceptions to this, but having someone manage your money for you adds nothing of value to your bottom line. In fact, these intermediaries directly detract value from your account.
A typical source of income for these “financial advisors” are commissions based on how much money they can bring into their company and into company investment funds. They are not financial advisors, they are sales people, and they’re selling you a subpar product that lines their pockets at your expense.
To put it simply, the average financial advisor and investment manager is a leech, feeding off of your hard earned money.
The company investment funds that they are forced to sell to you have high annual expense ratios (1% or more), and on top of that, they often charge you a fee to manage your money (often another 1%), just because they can.
With just a little bit of knowledge, we can manage our own money, avoid unnecessary fees, and outperform any financial advisor or investment manager trying to reel us in. There is a historically validated formula for long-term success in the stock market.
What is a Stock?
If you buy a share of a stock, you are buying a little slice of a company. For example, I could buy 1 share of Microsoft for about $200 as I write this.
Because I own that share, I am obligated to a portion of the company’s earnings each year, as long as I own that share. This portion of earnings that I get each year as a partial owner of Microsoft is called a dividend.
Microsoft is more focused on growth, so they have a relatively low dividend yield. They pay me $2 per year for each share I own. Instead of paying a higher dividend, they reinvest more money into their business.
These dividend payouts are the inherent value in owning stock in a company. When you are investing in the stock market, it’s important to know that you are becoming a partial owner of the businesses that you own stock in. Therefore, you get a portion of the business earnings each year.
Isn’t Investing in Stocks Gambling?
The stock market is not the place to gamble. You can gamble and speculate in the stock market, but that’s not the proven way to make money and profit in the market.
A stock’s value is derived from the cash it generates, which will theoretically end up in your hands in the form of dividends if you own that stock.
In 2020, most companies with a surplus of cash elect to perform stock buybacks, rather than dividend payouts, as they are more tax efficient.
However, the same principle applies. Company stocks (stonks) have inherent value based on their underlying cash-generating business.
There are daily fluctuations in the price, but these short term fluctuations are irrelevant to an investor. Stocks go up, stocks go down, but the overwhelming long-term trend is up.
There are sometimes wild, rapid price movements in the stock market. The thought of being able to invest $1000 and end up with only $900 at the end of the day is severely off-putting to people.
We can eliminate most of this extreme risk by not investing in individual stocks.
Don’t Try to Get Rich Quick
Patience is key.
In the long run, businesses operate and innovate and find new ways to make money. Old businesses die, and newer, better businesses take their place.
By investing in the broad market, we get a slice of the entire economy. We get exposure to all the good companies, and even bad and fraudulent companies like Lehman Brothers, who went bankrupt during the 2008 financial crisis.
But the index captures the average, and the average can handle the drag of a few bad apples.
When the Market Goes Up, Buy. When the Market Goes Down, Buy
Over multi-decade time frames, losing money in the market is incredibly unlikely. There’s no better way to preserve and increase your wealth than by regularly investing in the stock market, through its inevitable ups and downs.
Ignore the media sensationalism of daily price swings. Make a plan. Make systematic regular purchases into the market, and forget about it. Live your life.
When compared to the guaranteed return that a treasury bill provides, the stock market is inherently risky. But the cautious guarantee of investing in a treasury bill yields a measly 0.18%, compared to the 7% average year over year growth in the stock market over the past 100 years.
Historically, investing in the stock market has been the only reliable way to significantly increase your wealth without lifting a finger. Currently, the stock market is the only asset that gives you a chance of beating inflation.
In fact, it’s a gamble to not invest in the stock market. By avoiding the stock market, we are missing out on the benefit of making money from other people’s hard work in creating, innovating, and running a business.
By sitting on the sidelines, hoarding cash, we guarantee that we will lose to inflation year over year.
What Stock Should You Invest In?
The answer is simple: All of them.
We want a little slice of ownership of each and every business in each and every sector. Since we don’t have the ability to reliably pick winners in the market, the next best thing is to buy the whole market.
You should invest in a single, low cost, broad-market index fund.
To accomplish this, one fund, the Vanguard Total Stock Market Index Fund (VTI) is all that’s needed.
A total market index fund like VTI give us exposure to the entire United States economy, from the largest multinational Fortune 500 companies, to much smaller publicly traded companies.
And crucially, it’s incredibly affordable. Buying and selling shares of VTI is free, and it has an expense ratio of 0.04%
That means for every $10,000 invested, $4 per year is subtracted from your account balance to cover the overhead of running the fund. That’s a good deal
When you buy a share of VTI, you are getting a little slice of each of the thousands of publicly traded companies across the United States of America. From tech companies, to real estate trusts, to airlines, to banks, to software and IT services. Whatever the business, you become a partial owner. You gain exposure to each corner of the United States (and world) economy.
Picking (winning) individual stocks is a game of luck. Even professionals can’t reliably or repeatedly beat the market. And if you do decide to go down that path, be prepared to be consumed by it. Your Money or Your Life explores this concept in great detail.
By simply regularly investing in broad market index funds, we reap the benefits of the operations and innovations and profits of all businesses. The money those businesses earn then makes our way back into our investment accounts through dividends (or stock buybacks), with no effort on our parts.
This can be accomplished at any of the reputable, large online brokers.
Where Should You Invest?
As previously discussed, we should not give our money to someone else to invest on our behalf.
We have the ability to manage our money ourselves, by “setting it and forgetting it” with one of the major reputable online brokerage firms in the United States
I suggest Vanguard. They are the inventor or the low-cost index fund, and are owned by their fund-holders. This means that Vanguard’s interests and your interests are aligned.
However, other brokerages have caught on to Vanguard’s customer-oriented business model, and offer similar low-cost total market and S&P 500 index funds.
These other brokerages will work just fine (Schwab, Fidelity, TD Ameritrade come to mind). Vanguard, however, keeps things simple.
And with investing, simple is exactly what we’re looking for. Vanguard’s method for investing has stood up to the test of time so far. While other brokerages have caught up to their business model, Vanguard’s simplicity makes them a fine choice.
If you choose to open an account with Vanguard, VTI is the stock ticker you want to use to get access to the entire United States stock market.
Schwab’s equivalent total market index fund has the ticker SCHB, and edges out Vanguard with a 0.03% expense ratio.
Wherever you invest, just make sure you have access to a low-cost (<0.1% expense ratio), broad market index fund or ETF. If there’s no “total” or “broad” market index available, investing in the S&P 500 is also a great option.
What matters most is that the expense ratio on the fund you are investing in is as low as possible. 0.1% or lower is the most you should be paying to invest in an index.
What Account Type Should I Open?
If your employer offers a 401k plan, you should be using it. 401ks provide tax advantages, and often provide company matches to employee contributions.
At the very least, you need to be contributing enough to your 401k plan to get your full company match (if offered). Missing out on this match is leaving cold hard cash on the table.
You should look for the fund option with the lowest expense ratio. This will usually be a total market or S&P 500 index fund. In 401ks, the fund options aren’t always great, but the tax advantages and company matches included often make up for subpar fund options.
If you don’t have access to a 401k, you should open an Individual Retirement Account, or IRA for short.
You have two options, a traditional IRA, (which is an individual version of your 401k), and a Roth IRA.
In a Roth IRA, you pay taxes now, and never pay again later when you withdrawal money from the account.
In a traditional IRA, you defer your taxes, and pay them when you remove money from the account.
Either account will work fine. But if you’re young and have a low income, a Roth IRA might be a better fit.
After contributing to your 401k to get your company match (if offered), you should contribute to an IRA to continue investing and saving.
For 2020, you have the ability to contribute up to $6000 in your individual retirement accounts. And of course, you should be investing in low-cost index or mutual funds in these accounts.
If you’re able to fill up your IRA, then it’s time to up the contributions in your company 401k.
After all of your tax advantaged space (401k and IRA) is used up, then it’s time to open up a taxable brokerage account and use the same investment strategy as in your IRA.
Summary on How To Invest
Making money in the stock market requires patience. There’s no guaranteed way to get rich quick, but there is a way to get rich slowly.
The time tested formula on how to invest is to buy slices of the entire economy through low-cost broad market index funds.
If you haven’t already, open an IRA with Vanguard and invest in VTI (or another total market or S&P 500 index fund with a low expense ratio).
Be smart with your money, and buy more VTI with every paycheck, and you will profit a magnificent amount over the next few decades.