A Beginner's Guide to Investing

1. Compound interest can dramatically grow your wealth over time

An investment that doubles every 7 years will double twice every 14 years (2 x 2), resulting in a quadrupling in value.

The power of compound returns. Compound interest is the engine that drives long-term wealth creation in investing. When you reinvest your returns, you begin to earn returns on your returns, creating an exponential growth effect over time. This is why even small differences in annual returns can lead to dramatically different outcomes over multiple decades.

Rule of 72. A useful shortcut for understanding compound growth is the "Rule of 72." To estimate how long it will take an investment to double, simply divide 72 by the annual return percentage. For example, at an 8% return, an investment will double every 9 years (72 / 8 = 9).

Starting early is crucial. The exponential nature of compound returns means that time is an investor's greatest ally. Consider two investors:

• Investor A invests $5,000 annually from age 25 to 35, then stops ($50,000 total invested)
• Investor B invests $5,000 annually from age 35 to 65 ($150,000 total invested)
  Assuming an 8% annual return, by age 65:
• Investor A will have $787,000
• Investor B will have $724,000
  Despite investing three times as much money, Investor B ends up with less due to the power of compound returns over those extra 10 years.

2. Tax-advantaged accounts are crucial for maximizing retirement savings

Taxes represent the largest investment expense.

Understanding account types. There are three main types of investment accounts, each with different tax implications:

1. Traditional 401(k) and IRA: Contributions are tax-deductible, growth is tax-deferred, withdrawals are taxed as income
2. Roth 401(k) and IRA: Contributions are after-tax, growth and withdrawals are tax-free
3. Taxable brokerage accounts: No special tax advantages

Prioritizing contributions. To maximize tax benefits, investors should generally prioritize their contributions in this order:

1. 401(k) up to employer match
2. Max out IRA (Roth or Traditional)
3. Max out 401(k)
4. Taxable brokerage account

Long-term impact. The tax savings from these accounts compound over time, potentially adding hundreds of thousands of dollars to your retirement nest egg. For example, $10,000 invested annually for 30 years at an 8% return would grow to:

• $1,223,000 in a tax-deferred account
• $903,000 in a taxable account (assuming 25% tax rate)

3. Asset allocation is more important than individual stock picking

Study after study shows that asset allocation - not stock picking - accounts for the overwhelming majority of differences in the returns of different portfolios.

Understanding alpha and beta. Investment returns come from two sources:

• Beta: The return you get from exposure to the overall market
• Alpha: The return you get from outperforming the market (through skill or luck)

Focus on beta. For most investors, beta is far more important than alpha for three reasons:

1. It's the dominant source of returns for most portfolios
2. It's much easier to achieve (through index funds)
3. It's much cheaper to obtain (low fees for passive investments)

The futility of stock picking. Research consistently shows that even professional money managers struggle to outperform the market consistently after fees. One study found that 97% of actively managed mutual funds failed to beat their benchmark over a 15-year period.

4. Diversification across asset classes reduces risk and enhances returns

Diversification is a "free lunch." It allows you to avoid the usual tradeoff between risk and return.

Beyond stocks. True diversification means investing across multiple asset classes, not just owning many stocks. Key asset classes include:

• US stocks
• International developed market stocks
• Emerging market stocks
• Real estate (REITs)
• Bonds (government and corporate)
• Treasury Inflation-Protected Securities (TIPS)
• Commodities

Benefits of diversification:

1. Reduces overall portfolio volatility
2. Protects against severe losses in any single asset class
3. Potentially increases returns by allowing higher allocations to riskier, higher-returning assets

Sample allocation. A well-diversified portfolio for a long-term investor might look like:

• 50% stocks (US, international, emerging markets)
• 20% bonds
• 15% real estate
• 10% TIPS
• 5% commodities

5. Low-cost index funds and ETFs are ideal for most investors

ETFs are a great (relatively) new financial instrument that acts like a combination of a stock and a mutual fund and provides a low-cost, tax-efficient way to get broad exposure to the markets.

The case for indexing. Index funds and ETFs offer several advantages:

• Low fees (often 0.1% or less annually)
• Broad diversification
• Tax efficiency
• Simplicity

Impact of fees. Even small differences in fees can have a huge impact over time. For example, $10,000 invested for 30 years at an 8% return:

• With a 0.1% fee grows to $98,900
• With a 1% fee grows to $85,200
  That 0.9% difference in fees costs nearly $14,000 over 30 years.

Recommended ETFs. Some low-cost, broadly diversified ETFs to consider:

• US stocks: Vanguard Total Stock Market ETF (VTI)
• International stocks: Vanguard FTSE Developed Markets ETF (VEA)
• Emerging markets: Vanguard FTSE Emerging Markets ETF (VWO)
• Bonds: Vanguard Total Bond Market ETF (BND)
• Real estate: Vanguard Real Estate ETF (VNQ)

6. Develop a systematic investing plan and stick to it long-term

Creating a lockbox is relatively simple. Choose your asset allocation, pick good assets, and keep your account on autopilot going forward.

Set clear goals. Start by estimating how much you'll need in retirement and work backwards to determine your required savings rate. A common rule of thumb is to aim for 25 times your desired annual retirement income.

Automate your investments. Set up automatic contributions to your investment accounts to ensure consistent investing regardless of market conditions. This also helps avoid emotional decision-making.

Rebalance periodically. As different assets perform differently over time, your portfolio will drift from its target allocation. Rebalance once or twice a year by selling overweight assets and buying underweight ones to maintain your desired risk level.

Stay the course. Resist the urge to make major changes to your plan based on short-term market movements or news. Successful investing requires patience and discipline over decades.

7. Keep most investments in a "lockbox" and limit active trading

The sandbox lets you make a compromise with yourself-if you really think that "pets.com" is going to be the next Walmart, then by all means, put a little of your sandbox account into it, but don't endanger your retirement by investing all of your assets in it.

The lockbox concept. Keep the vast majority (80-95%) of your portfolio in a diversified, low-cost, passive investment strategy that you rarely touch. This prevents emotional decision-making and excessive trading, which often lead to underperformance.

The sandbox approach. If you enjoy active investing, set aside a small portion (5-20%) of your portfolio as a "sandbox" where you can experiment with individual stock picking or other active strategies. This satisfies the urge to be more hands-on without risking your core retirement savings.

Dangers of frequent trading:

• Higher transaction costs
• Increased tax burden (in taxable accounts)
• Tendency to buy high and sell low based on emotions
• Underperformance compared to buy-and-hold strategies

8. Start investing early and consistently to reach retirement goals

Jill and Average Joe both manage to make saving money a priority. Over the long-term each manages to put an average of 10% of total income into a retirement fund, only taking a break for three years in their mid-30s when family expenses and job concerns made saving too much of a sacrifice.

The power of time. Starting to invest early in your career is one of the most impactful financial decisions you can make. Even small amounts invested in your 20s and 30s can grow to substantial sums by retirement age due to compound returns.

Consistency is key. Regular, consistent investing over decades is far more important than trying to time the market or pick winning stocks. Dollar-cost averaging (investing a fixed amount at regular intervals) helps smooth out market volatility and removes emotion from the process.

Overcoming obstacles. Life will inevitably throw financial curveballs – job loss, medical expenses, etc. The key is to get back on track with your investing plan as soon as possible. Even if you have to pause contributions temporarily, avoid withdrawing from retirement accounts if at all possible to preserve long-term growth.

Last updated: November 17, 2024