How to FI – Invest in Index Funds

In the last post we learned the basics of how to save a pile of cash.  In this post, we’ll talk about what to do with that money.

There are a lot of different ways to invest.  Some are very complicated, and some are extremely simple.  Within the FI community there seem to be two main routes that people take: Index funds and Real Estate.

I will get specifically in to what Mr. and Mrs. DS do in a future post.  For now let’s learn what index funds are and how to get some!  

Index Fund (Stock) Investing

Many people are intimidated by stocks.  They seem confusing.  All the jargon and graphs that are thrown about on the news when discussing stocks add to this.  It turns out though, that successful stock investing does not have to be confusing.  It is actually one of the simplest forms of investing you can do.

Index funds are so easy that I tend to find them dull.  However, the fact that they are dull may be just the reason you should choose them.

If you don’t want to spend a lot of time learning about investing, then index funds are the obvious choice.   Unlike real estate, they are totally passive.  The best thing you can do is invest your money and then forget about it.

If you choose to invest in index funds, does this mean you are choosing lower market returns in exchange for getting to be lazy?  No!  Historically, when not considering leverage, stocks have been the best performing asset class.  

Index funds are a case where you get to have your cake and eat it too.

The great irony of investing is the more you watch and fiddle with your holdings the less well you are likely to do.  Fill your basket, add as you go along and ignore it the rest of the time.  You’ll likely wake up rich.

From  Stocks — Part VI: Portfolio ideas to build and keep your wealth, by JL Collins

Index Funds – What Are They?

First, what is a stock?  A stock is just a piece of a company.  If you buy a stock you own a piece of that company.  When a company makes a profit, there are a couple things it can do with this profit: it can reinvest it into the company to grow the overall value of the company (which hopefully makes the stock price go up), or they can pay the profit out to the owners in the form of dividends.  As one of the owners, you would get a piece of this dividend payout.

The challenge with owning a single stock is that if the company you have stock in goes out of business, you lose your hard earned investment.  Ouch!  Don’t worry though, this is where the index fund comes in.  

An index is a group of stocks that somebody keeps track of for some reason.  Maybe they think a particular index is a good indicator of the health of the economy, or of some sector of the economy.  For example, the S&P 500 tracks the 500 largest publicly traded companies in the US.

An index fund is something you can invest in that pools lots of investor’s money and purchases stocks in all the companies in a particular index.  You then become a part-owner of each of those companies.  This is cool because if you buy a share of an index fund and one of the companies in it goes out of business, the failed company just drops off the index and another company jumps in.  You don’t lose all your money.  In fact, short of the entire economy collapsing into some sort of post-apocalyptic zombie chaos, a large index fund like the S&P 500 can’t really go to zero!

One of the best things about an index fund is that, unlike actively managed mutual funds, the company administering the fund doesn’t need to employ an expensive rock-star stock picker to decide which stocks to buy.  They just buy the stocks in the index.  This keeps their expenses and your fee low.  That low fee, over the long run, typically makes index funds perform better than the actively managed competition.

Index Funds – How to Invest

So how do you invest in an index fund?  It’s so easy!  This is one of the best things about them!  It’s really not any harder than opening a checking account.  Actually maybe easier since you never have to go to the bank!  Simply head over to Vanguard.com, open an account, pick an index fund (hint get  VTSMX or VTSAX).  Start transferring money, and voila!  You’re investing!  Set up the money transfers to be automatic and you won’t ever have to think about investing again until you’re retired and want to use the money.

Why Vanguard?  Their index investing fees are the lowest available.  These low fees will make a HUGE difference in your long term wealth.  They can do this because there are no owners/shareholders to skim money off the top.  They are investor owned, which means if you invest with Vanguard then YOU  will be one of the owners!  Any profits are passed back to the investors in the form of lower fees!

“Wait a second Mr. DS, I signed on and there are a TON of funds to choose from.  Which should I pick?  How does my company 401K fit in?  A coworker also told me I should be using an IRA?  What the heck do all these letters mean?”

I’ll dive deeper into some of these in future articles, but to spare you the suspense, here are the answers to these questions, with relevant links in case you want to learn more:

Which funds to pick:  VTSMX or VTSAX, which is the Vanguard Total Stock Market Fund.  You will own a piece of basically every publicly traded company in America.  Perhaps consider sprinkling in 10-30% bonds using VBMFX, the Vanguard total Bond Market Fund.  Statistically bonds are actually a bad idea, but it might make you feel better during the next crash.  See this excellent post from JL Collins for more information on why you might want to put 100% into stocks, and this post from Millennial Revolution for an argument to add in some bonds.  The choice is yours.

401Ks, IRAs, and Roths, oh my!: An IRA is an Individual Retirement Account.  I have no idea what 401k and Roth stand for.  Fortunately, the abbreviations don’t matter.  What does matter is that you use these accounts to their max!   All of these accounts get you some sort of tax advantage.

If you contribute to a tradition IRA or a 401k you get to deduct that money from your taxable income.  If you max out all of these accounts you will save thousands of dollars on income tax.  What to do with the money you save?  Invest that too!  Note that whenever you go to pull the money out of your IRA or 401k you will owe income tax at that time.  

“Wait a second Mr. DS… Whether I pay tax now or tax later, I’m still paying taxes.  What’s the point???”

The point is that when you stop working you won’t have much or any income coming in, so you will be in a much lower tax bracket.  This will save you a ton of money!

But wait, there’s more!

Follow the advice in this article by the Mad Fientist, and you may never need to pay taxes on this money.  That is a HUGE benefit!  Because of the Mad Fientist article, I’d recommend going the traditional IRA route in lieu of the Roth.  No sense getting taxed at a high rate now if you can just not pay any taxes ever!  That said, there is an income limit to the traditional IRA that is lower than the Roth, so if you make too much money you may be forced to use the Roth.  

Here is what you should do in order of priority:

1. Fund your 401k enough that you get your employer match. 
   1. This is free extra money and you want it! 
2. Max out your traditional IRA to the legal limit ($5,500 in 2018)
   1. Invest this in VTSAX
3. Max out the rest of your 401k to the legal limit ($18,500 in 2018) before investing in anything taxable.  
4. Put any extra money into a regular taxable brokerage account with Vanguard.  

If you max out steps 1-3 above you will have invested $24,000 tax deferred.  If you are in the 24% federal tax bracket, and happen to live in Idaho with a marginal tax rate of 7.4%, you will have saved (24+7.4)/100 * $24,000 = $7,500 per year!  Invest that every year and after 10 years you will have an extra $104,000!

Note that I am not an accountant.  You should check with your accountant before diving into any of these since there are a lot of rules to them, and if you make too much money you may not qualify (poor you).

In the next article we’ll take a tour of real estate investing.  That said, if you just save the majority of your income and invest it in low cost index funds you will win at the game of money without doing anything else.  

Cheers!