This series of newsletters is geared toward teaching my kids about about how to invest their money. We have the luxury of already being rich, and the implicit goal here is for my kids to learn how to stay rich. It’s easier to stay rich than to get rich, but it still might not be as easy as it looks. There’s always the temptation to spend too quickly, or to get even richer through get rich quick schemes.
The posts here are going to jump around a lot because there is an endless amount to learn. My eventual hope is that everything coalesces into something I can order into a book. But, because I’m starting from a position of guiding my kids into investments, I’m going to start with some specifics, branch out, and return to other topics as necessary.
Big Picture: What am I doing when I’m saving?
Economically, you can think of being rich as having a lot of wealth. Wealth is stored up assets. Assets are things that have value. Money is one particular kind of asset, because it’s the one asset you can legally trade for any other asset. Income is money (or other assets) you gain earn or are given over a period of time. If you earn $100 at work, that’s income. It’s also an asset. If you take that $100 and spend it immediately on dinner, you’ve consumed it. If you don’t spend it, but put it in the bank, you’ve saved by adding it to your wealth. Really, saving is about time. You are choosing to consume now or consume later.
Saving is all about time.
This choice between now and later, and understanding our point in time is what makes saving so complicated. It’s complicated, because time has several effects that seem to work in opposite ways.
On one hand, time withers away the value of a lot of assets. Including money. Sometimes it’s obvious. That dinner you paid $100 is no longer worth anything if you let it sit for a week. Time also runs down the value of a lot of things simply based on use. You can think of big purchases, like a car, as things you consume slowly over time.
These are examples of something happening over time to the asset we’re talking about. The food goes bad. The car gets worn out.
What’s happening when there’s “inflation”? We’ll eventually learn than inflation can mean several different things, but what I’m asking about here is the situation where you save your $100 for a year and find out that over that time, the price of other things has gone up. That $100 dinner you didn’t buy today suddenly costs $110 and you can’t afford it.
This is a little different than the last situation, because nothing happened to your asset. Your $100 didn’t get used up or worn out. It stayed the same and the rest of the world changed around it.
This situation can happen for two basic reasons. Usually, both are going on at once.
It could be that specific things get more valuable. Maybe the desire or demand for eating out goes up, or food gets more scarce so the supply goes down. Those things would make the price of the dinner go up. But they’d also make the price of other things go down. Maybe your $100 won’t buy the dinner anymore, but it’ll still buy a coat or a game.
If the price of everything (or almost everything) goes up, it’s usually because there’s literally more money available. At any one moment in time, there are X number of dollars in circulation. Suppose the government simply adds $10,000 to everyone’s bank account. Everyone will be richer, but that money that was already in your bank account, that $100, won’t go as far. Because if you suddenly have $10,100 in your bank account (and everyone else does too), when you go out and compete for buying things, everyone will have to offer more.
In these ways, the passage of time makes your money less valuable. Use it or lose it! But wait? Really? Shouldn’t I be saving?
Yes, because there are other forces at work that can make time increase the value of your assets. Which means time also works to grow your money.
The main thing going on here is that even though the amount of money in circulation might be growing, at any one time, there’s only a limited amount. So if you have extra money today, you can trade it to people who need it. Interest, like you earn from the bank, is the price you charge for lending the money you’re not using out to somebody else. So if you get 1% interest, for every $100 you lend the bank in a month, they will give you $1.
Of course, the biggest issue with lending the someone your money is the risk they won’t pay it back. So in addition to the time component of interest, the bank, or whomever, has to promise even more extra, a risk component, to make it worth the risk that you lose your money. Putting your money in a bank is generally a low risk move because banks are legally required to insure your deposit and give it back. So that’s why you’re lucky to get even 1% interest. If you go to another bank that doesn’t guarantee to insure your money, you might get 2% or more. Based on how risky it is to deal with that borrower.
Fundamentally, both of these situations require you to recognize two things:
First, you have to have money that you don’t immediately need. You need to know what you can get buy with, and when you will need the extra.
Second, you have to recognize the opportunities of lending that extra money out. That is how you make money.
Notice that up to this point, we’re basically just talking about money and not other kinds of assets. As we’ll see, other assets work pretty much the same, but money is the first thing to understand because everything else is measured in money. So, your savings in money terms can be money in an interest bearing account, or a bond, which is just an IOU that works exactly like I’ve laid out. If you get a bond, you are paying money today for a promise to return that money with interest to offset the fact you don’t get to use it while someone else is.
So when we’re saving, what we really want to do is protect against the situations where time erodes our wealth and take advantage of the opportunities time gives us to increase our wealth.
Moving beyond money to invest in other assets
As I said, money is the asset we use to do trades and it gets the legal backing of the government. Dollars are fiat money because it’s just an asset created for this purpose. A government could use actual physical stuff, like gold and silver for this purpose too. Some people will tell you this is better, but it’s probably not.1 Anyway, because the money you aren't spending will probably decline in value as it sits there, we want to not let it sit there. Instead of letting it sit in your wallet, you can lend it to the bank. That's what you're doing when you deposit it. Or, you can lend it to a government or business in exchange for a bond, which is a promise to repay your money plus interest.
Investment is when you spend your money on another asset.2 One that you’re not going to consume. An investment asset is something you expect to be able to turn into more money down the road. Think of it in contrast to dinner. You buy dinner and then literally consume it. A car might be a consumption asset. You can spend years “consuming” the value of the car, but it rarely goes up. A house is often an example of both investment and consumption. You’re using the house, and you have to pay to keep it up, but it the building might still have value when you’re done and the land it sits on is a scarce resource, so in that sense it (often) goes up in value.
You can think of basically two kinds of investment assets.
The first kind makes you money by owning it. You buy a farm and use it to make money. Or you buy a bond and earn interest on it every month.
The second kind is something you expect to make your money on by selling for more in the future. A Pokemon card, for example. Or a piece of ownership in a company.
In practice, most investments have some of both of this going on. You hope an investment will pay you some earnings, and you also hope you’ll be able to sell it for a bunch more than you paid for it. For example if you buy shares of Apple, they will pay you a dividend, which is your share of the profits Apple distributes to their owners. But also, you expect your Apple shares to become more valuable as they keep making stuff people want to buy, and eventually, when you need the money, you can sell some of your Apple stock and buy stuff with the money.
It’s worth thinking about that this second type of investment is basically making a bet. So you come back to risk. Apple is a pretty safe bet to at least be in business in 10 years. Game Stop is not. Which is fundamentally why the price of Apple is high and the price of Game Stop is low. Not many people want to place high risk bets.
In practice, most of the investing you’ll do is based on companies. When you buy a stock, you’re buying a share of ownership in the company. It’s just a very small amount. So if you buy a share of Apple, there are 15.9 billion shares. So one share gives you only 1/15.9B worth of ownership in Apple. Just like Steve Jobs, except on a smaller scale.
There are thousands of companies, and it’s really hard to tell which ones are going to succeed and which ones aren’t. In fact, most economists believe the Efficient Market Hypothesis. The EMH suggests that, over time, nobody can “beat” the stock market by consistently picking stocks that return more than the market average. Think about it this way. Even a great company is bound to be wrong sooner or latter. So Apple might make a ton of money now, but if you had to make a bet on the future, you wouldn’t be 100% sure that Apple is going to continue to be more profitable than Google or Tesla or dozens of other companies. Chances are, some other company will be a better bet. So instead of betting everything on one company, you are better off dividing up your money and making a lot of smaller bets. This way, you do lose out on the possibility of getting the highest possible return (e.g. it would have been better to bet on everything on Apple back when it was worthless and looked like it would go bankrupt), but you reduce your risk by a huge amount.
Mutual funds are investment products that let you do just this. The investors who create a mutual fund buy a whole set of different company’s stocks and then turn around and offer them to sale to other investors. So instead of going through the trouble of buying ten different stocks to spread your money around, you can just buy a single mutual fund that has those 10 different stocks. Also understand that ETFs (Exchange Traded Funds) are basically the same as mutual funds.3
Also, because mutual funds are basically just something that gets set up by investors around this concept of risk pooling, they come in hundreds of different types. Some of which overlap. The basic ways to think of the differences are:
Management. How does the fund manage its portfolio?
Actively managed funds are run by people are who actively buying and selling parts of the portfolio in order to try and make the most money (or, sometimes, to attain some other goal, keeping the value of the investment from falling). For example, maybe the managers think Google is a better bet than Apple? So maybe they have some of both, but they add more Google than Apple into their portfolio.
Passively managed funds are run by rules. For example, the S&P 500 Index is basically a list of the 500 most valuable publicly traded companies, weighted by their relative value. A mutual fund that follows the S&P 500 doesn’t make any choices; it just blindly follows the rule. If a company falls out of the S&P 500, the manager of the fund sells it. If a company gets proportionately more valuable, the manager buys it.
Actively managed funds are more expensive to buy into, because you’re paying the fund managers to go out, gather information, and make decisions about what to put in their portfolio. Is that extra expense worth it? Well… usually no. Remember the EMH. It implies that over time, you can’t beat the market So to be worthwhile, an actively managed fund has to predict what's going to happen. Which is probably can't do.4
Example: The Vanguard S&P 500 Index fund is a passively managed mutual fund that follows the S&P 500. The Vanguard PRIMECAP Core Fund is actively managed but also invests in similar companies.
PRIMECAP has an expense ratio of 0.46% and the 500 Index fund has a ratio of 0.04%. Expense ratio is basically how much the fund’s manager’s take to manage the fund’s assets. So generally:
If you invest PRIMECAP, you will pay $0.46 for every $1,000 you invest.
If you invest in the 500 Index, you will pay $0.04 for every $1,000 you invest.
For that extra money, PRIMECAP has had better performance over the last year. It lost 12.4% of its value, while 500 lost 18.2%.
So if you had invested in PRIMECAP, your $1,000 would be down to $876
But if you invested in 500 index, your $1,000 would be down to $818.
On the other hand, if you look at the 3 year return:
PRIMECAP gave a return of 6.91% per year. Adding in the expense ratio, this means that had you invested that $1,000 three years ago, you’d now have about $1,205.
With the 500 Index, you have an average annual return of 7.62% over the same 3 years. Plus its lower expense ratio, so if you’d invested $1,000, you’d end up with about $1,245.
Obviously $40 over three years isn’t a huge difference. but it’s still a difference. Importantly it’s a difference that adds up over long periods of time.
As a rule of thumb, passively managed funds are probably better over the long-run. If you’re saving for retirement, five or ten or forty years down the road, those little amounts are going to add up.
On the other hand, if active management has an advantage, this example probably shows it in that an actively managed fund that’s not blindly following the market might suffer bigger losses in a shorter period of time. If you’re a year away from retirement instead of 40, that risk of a lower return is a lot bigger.
This illustrates an important principle. Know when you are going to need to cash in your investments. The closer you are to actually needing that money, the safer your investments need to be. Moving to,(or at least having proportion of your money invested with actively managed funds) starts to make more sense as you get closer to needing the money.
Assets. What types of things is the fund investing in? So far, we’ve just talked about mutual funds that are collections of company stocks. But just like Funds can be managed differently, funds can invest in different types of assets, not just companies. There mutual funds that invest in, among other things:
Specific types of companies. Large companies, small companies, health care or real estate companies, foreign or domestic. You would want to invest in these if you think a particular place, industry, or kind of company is going to do especially well.
Physical assets like Gold or other precious metals.
Bonds and funds composed of a lot of different bonds are kind of tricky. Remember from before that a bond is basically just a loan to a government or company. You give them money and they promise to pay it back with interest.
The upside of bonds is they’re pretty low risk. Companies and governments generally have legal obligations to pay lenders first if they can’t pay everyone. Governments can literally print money if they need to. So while printing money would be bad for lots of reasons, if you held a bond, you might prefer the government to print money to pay you back than to not pay you back at all.
In the simple case where you buy a bond and the borrower pays you back, people think statically. I lend $100 today and I get back $105 in a year. That’s 5% interest.
But remember that there’s inflation. If there’s 3% inflation, it means the $100 you started off with would buy you $100 worth of stuff before you invested. After that year with 3% inflation, the same stuff would cost $103. Since you made $105, you’re still $2 ahead. But it’s $2, not $5.
Further, you actually have to pay taxes on the interest you earned. So if you pay 25% Federal taxes (a high-middle income amount), then you have to pay $1.25 in extra taxes on the $5 interest you earned.
Taken together with inflation, this means you only come out $0.75 ahead. If inflation is, say, 8%, then you would have been better offer spending your money rather than buying the bond.
That being said, if you’re trying to save money, at 8% inflation, you’re still better off buying the bond that you were just letting the $100 cash say in your wallet.
If you keep the cash in your wallet for a year, the $100 leaves you $8 short of buying the same thing you could have bought a year ago.
If you invest in the bond, you’re only $4.25 short (because you have $105-$1.25= $103.75).
Everyone loses the race against time.
What gets complicated is that in financial markets, you can buy and sell the bonds you bought to someone else. Suppose you’ve got this $100 savings bond in your pocket good for $105 in a year. Six months down the road, you really need some cash. Well, you can just sell the bond.
What price you get depends on the inflation and the interest rates being offered on new bonds. If the government starts offering a higher rate on new bonds, it’s going to drive down the price of the old one. If someone could go out and get a bond that pays them 6% on their $100, you’ll have to take less for your bond that pays 5%.
So if interest rates rise, the price of existing bonds fall. If the rate falls, the price of existing bonds rises.
A mutual fund (or ETF) that’s composed of bonds is, by definition, composed of existing bonds. So while you might think, “hey, interest rates are going up, now is a good time to buy high interest bonds”, understand that the value of all the bonds already out there on the market is falling. To get the higher rate bonds, you have to buy newly issued bonds.
Why not all mutual funds and all in on the market? Why diversify? Because of variance. In any given year or two, the stock market might go up or down 20-30% in a year. So if you have $100,000, and you know that in two years you want to buy a house, the chance of only having $70,000 is a big problem. If you know you don’t need that money for much longer… say 10 years, then it’s not a problem. As a general rule of thumb:
When you have longer run open ended financial goals, you should be looking to invest in more aggressive stocks.
The closer you get to needing to use your savings for specific things, the more conservatively you should invest them in order to make sure you have what you need.
Even if you don’t have any immediate needs, you should diversify your portfolio between different funds and also have some money market and bond funds. This will help protect you in case a particular fund or index does poorly, and in case you have unexpected expenses.
Financial Advisors. A lot of people pay financial advisors to make these kinds of decisions for them. I’m skeptical because of two reasons. First, I’ve already laid out the basics… it’s not that hard. They aren’t going to do anything magic that you don’t know about. If they promise you a bigger return through active trading, then refer back to the EMH. Second, there’s a principle-agent problem with financial advisors. They, as the agent, often get paid through other sources or on commission whether you make money or not. The other sources are often conflicts of interest (example: they are employed by a company that sells investments they “suggest” you invest in instead of other, less expensive options. Basically, unless you are extremely wealthy and doing a lot of really complex financial transactions, most people are better off with spending the time to set up their investment plan right at the beginning and then just not altering it very much.
So, what do I do? All this this stuff is good to know for the purposes of understanding why you should do what you’re going to do, but the actual steps are pretty straightforward.
As a young person, save what you can for retirement. To the extent your company will contribute to your retirement 401(k) make sure you put in enough money that your company maximizes the amount they give you. It doesn’t have to be a lot. A basic concept in finance is called the Rule of 72. It suggests that if you invest your retirement investments mostly in the market, they will likely double in about 7 years. So by the time you’re ready to retire, even that relatively small amount will add up. Most of the time, employer matching stops at about 4-5% of your salary (meaning if you contribute 4-5% of your salary to your 401k, they’ll give you an extra 4-5%). So, 5% is a good basic starting point.
When you start working and paying regular bills, figure out how much you spend in a month or to. Your short-term savings should probably be a couple months’ expenses. So if you spend $500/month, you probably want to keep $1000 in a savings account if you can. And have an extra $500 cushion in your checking account. So theoretically, you never want to go below $500 in your checking account, and if you need to, you have two more months of savings in your savings account.
As you save more money, it’s time to start investing it. As a general rule, if you don’t have a specific goal (like buying a house in the next few years) that you want to use your savings on, you probably want to have about 70% invested in stock based mutual funds/ETFs (like the S&P 500 index funds described above) and 30% in money market and bond funds, depending on what looks good at the moment. Because interest rates still seem to be going up, right now that is probably being heavier on Money Market Funds because as discussed, bond funds are actually going to fall as rates rise. A simple starting portfolio (at Vanguard Brokerage) might be:
S&P 500 Index ETF (stock symbol: VOO) ~ 40% of total. This is your basic, passively managed stock market index ETF. It will give you basically the market return on your investment.
High Dividend Yield ETF (VYM) ~ 15%. This ETF is also a passively managed stock index, but instead of tracking the 500 biggest companies, it tracks a set of companies that consistently pay high dividends. Because dividend paying stocks tend to be larger, more established companies, this is a slightly lower risk ETF, and one that is likely to give you a continuing stream of income in the form of the companies dividends (which should be set up to automatically reinvest into more of the ETF). This isn’t dramatically different from the 500 index, but again, the idea is to not put all your eggs in one basket and strategy.
International Dividend Appreciation ETF (VIGI) ~ 15%. This is basically the same strategy approach as VYM, but instead of domestic companies, it uses an index of international companies. Thus, spreading some of your money here will is a way to spread your risk. If the US does particularly badly but other countries do well, then it might offset your losses.
Federal Money Market Fund (VMFXX) ~ 30%. This is the default “money market” fund at Vanguard. If you put your money here, you’ll get an interest rate that’s better than what you can get from most banks, but probably not as good as you get from a lot of bonds. On the other hand, you don’t have the potential to lose significant money of bond funds in the current situation where interest rates are rising. Once interest rates stabilize, it would be reasonable to look for a bond fund for part of this money, but the upside right now is not very good.
You’ll hear gold is better than a fiat currency like the dollar because it’s inherently “worth something”. But if you think about it, that’s not actually true. Historically gold as been used as a currency because it’s durable, but there’s no guarantees of anything. And the price of gold itself fluctuates all the time. Ostensibly having a gold or silver standard lets you get around the problem of, in a fiat currency, the government suddenly changing the supply of currency to serve some purpose (like paying off debt) at the expense of the public.
Except… from your history classes, you will remember the Cross of Gold and Bi-Metalism, and the Panic of 1873. A major depression was caused by governments (Germany and the United States) suddenly deciding to no longer accept silver as legal tender. Going back further, Spain went from the richest, most advanced country in Europe to being backwards by mistaking all of the goal it extracted from the Americas for actual wealth. If you think of gold as fundamentally yellow rocks, they developed a lot of cutting edge technology (for the time) and spend enormous resources to the end of carrying a bunch of yellow rocks from around the world back to Spain.
The lesson here is that there’s always some level of societal risk involved in money. Money is used to trade and store real wealth, but it’s not that real wealth itself. Whether it’s gold or green pieces of paper, it’s a social construction. It’s useful, but don’t forget that society is continuously changing the rules of the game as it goes.
Are saving and investment the same thing? In practice yes, but technically no. When we are “saving” in every day life, we are putting aside some money instead of immediately using it to consume. But unless we literally are just keeping the money in a bank or sitting on our desk, we’re actually buying investments that we hope will make us more money and/or be more valuable in the future. Investment is buying assets we value because we expect them to produce or grow in value. Saving is not consuming.
The main difference between an ETF and a mutual fund is how they are packaged up. An ETF is purchased just like a stock. You can go buy as much or as little as you like on a public market, which shows the price it’s being traded at live. A mutual fund generally doesn’t have live price updates. Instead, you buy into the mutual fund, and they do some accounting to settle all the amounts every day. The details aren’t that important, except for this: sometimes your brokerage charges fees for one but not the other. In many retirement accounts where you are investing a few dollars every couple weeks, mutual funds are used. If you are making single purchase though, it might be cheaper to do an ETF (and you also get live pricing). The bottom line is to probably default to ETF for investment accounts and mutual funds for retirement accounts, but look at the fees and specifics.
One way to think about the EMH is to think about the difference between a game its outcome. A game goes on for a while, with the opposing teams and players trying to score. The final score is the result. A passively managed fund basically looks at the results and adjusts accordingly. It used the results of a game to inform its next bet. Because a new game starts every day. An actively managed fund is making bets about the outcome of the game before it’s over. They’re using their best guess to try and predict the outcomes. Because they’re good at what they do, they’re usually right, but there’s no guarantee. When something unexpected happens and the team that looks like it’s going to lose ends up winning, they tend to lose those bets. Passive investing, since it only looks at the results, doesn’t lose these bets. They don’t make money with predictive betting though. But the EMH has tended to show that over the long-run, you can’t always be right in your predictions. The results are always right because… well… they’re the results.