GET SMARTER ABOUT MANAGING YOUR SAVINGS
Some thing from this post: One of the main areas where I’ve just been ignoring the issue is with investing. For many years I squirreled away any excess cash I earned in a checking account rather than investing it because I was afraid of making the wrong choice about where to put it. While managing to save anything in the Bay Area where the cost of living is ridiculous should feel like an accomplishment, I knew I was missing out on earning higher returns, I was forgoing tax advantages, and I was probably getting killed by inflation. But still, I never felt like I had the time to do the research I wanted to make an informed choice. Instead I would put off thinking about it until “later.”
Q: HOW SHOULD I PRIORITIZE WHERE MY AVAILABLE CASH GETS ALLOCATED?
I have read a ton of articles, blogs and books about financial planning and investing since starting this project. While there’s seemingly overwhelming agreement out there on the importance of having an emergency fund and paying off credit cards, after that things get a little fuzzier. Many years of strategy consulting have predisposed me to using frameworks as a way to make sense of complex topics. So below is my attempt to create a simple framework to help prioritize financial objectives. Obviously I’m omitting a lot of nuance in favor of simplicity and clarity, but for me it’s always helpful to start simple and then add on layers of detail.
Start an emergency fund
If life throws you a curveball, like a job loss or a major expense, your financial situation won’t force you into making hasty decisions. I’ve frequently seen 3-6 mos of living expenses as the recommended amount to set aside in a pretty liquid account. You could always build up to that as you fund some of these other high priority areas in parallel.
Take advantage of 401(k) matching
It’s basically a guaranteed way to double your money.
Pay down credit cards
Credit card loans are crazy expensive.
Pay down mid-rate loans (~5-8%)
It’s hard to come out ahead if you’re using cash to invest instead of paying down these loans because it’s unlikely that your after-tax investment return will be much higher than what you’re paying to borrow.
Set aside money for big, near term expenses
It’s risky to put money in the market if you’ll need it in the next 5 or so years. Note that there’s always a tradeoff between spending in the near term and saving for retirement. The earlier you start saving for retirement, the more opportunity you’ll have for returns to compound. However, it’s also important to enjoy life in the present which can mean spending in the short term. I built a spreadsheet to model out the long-term impact of short term spending which has made me feel much more confident about making larger purchasing decisions. Ping me if you’d like it.
Fund retirement accounts (401K, Roth IRA, IRA)
Retirement accounts have tax benefits which is why I have them positioned ahead of taxable accounts. However, it’s important to weigh the tax advantages you’ll get against the investment options you’ll have access to and the fees you’ll pay. This can vary greatly.
Fund college savings accounts and other taxable investments
I lumped these two together because personally I’m planning to fund some of my kid’s college education from a 529 college savings plan and some from taxable accounts. There are some tax advantages associated with vehicles like 529 plans, but you’ll also pay a 10% penalty if you decide to use the money for something other than education down the road. You also want to make sure you have your retirement needs covered because you can get financial aid for college but not for the old folks home.
How should I be investing
A: I'M FOCUSED ON BUILDING A WELL DIVERSIFIED PORTFOLIO WITH LOW FEES (A.K.A., LOW COST INDEX FUNDS)
To handle the last two categories on the table above, I needed a point of view on how to invest. Gulp! I think it was an undergrad financial accounting class I took that scared me off of investing for years. Our final project was to pick a company, analyze its financials and make a recommendation on whether or not to buy the stock. We picked Pyramid Brewing Company and I still remember that our final recommendation was to “buy the beer, not the stock.” My team put so much effort into making that recommendation that what I took away was just how much research is required to make a good decision. That experience, coupled with having a front row seat to the dotcom boom and bust, where start-up valuations were completely disconnected from a company’s fundamental value, has always made me leery about investing. You could do a lot of research and still get burned in an irrational market.
So while I may be taking a more active role in designing my financial life, from an investing standpoint I’m taking a passive approach. Instead of actively picking stocks or trying to get access to a really talented money manager to invest with, I’ve bought into a diversified portfolio that I plan to hold over the long term. The underlying philosophy of passive investing is that you can’t beat the market by identifying mis-priced securities or trying to time the market...at least not in a way that will generate returns that exceed the costs involved to get those returns.
There’s a lot of widely accepted evidence out there indicating that this is a really solid strategy. A good read on this topic is “The Four Pillars of Investing” by William Bernstein where he shares a lot research on why this is a sound approach. There’s also a really good recent article by Stanford GSB professor Charles Lee called “How to Stay Rational When the Markets Go Crazy” that highlights some similar ideas about the value of investing in a diversified portfolio for the long term.
From some work I’ve done to model out how much I will need to fund a comfortable retirement, I have been astounded at how sensitive the model is to inflation and investment returns. [Translation for the non-excel geeks out there: Holy cow! The impact of fees and inflation, compounded over time, is really significant, even though a percentage point seems like something you should be able to just shrug off.]
With all this in mind, I’ve been focusing on investing in low cost index funds. Check the Resources tab for more info on what index funds are.
HOW SHOULD I EXECUTE THIS INVESTMENT APPROACH?
A: I'M USING VANGUARD FUNDS AND ROBO-ADVISORS
An investment philosophy is only useful if you actually put it to work. I’d imagine taking the next step and moving money around is where a lot of people get hung up. That was certainly true for me. First, there’s the decision of what company you’re going to entrust with the privilege of managing your hard earned cash. Then there’s the emotional moment where you actually transfer your cash, thereby putting it at risk by investing it. Sure, it may be a smart risk you’re taking that history has shown works out over the long term. But the disclaimer you often see plastered all over anything related to investment advice, “past performance is not indicative of future results,” is true. Nobody knows what the future holds, so there’s always a risk. At some point your portfolio will likely be down...possibly way down.
To address the point about picking the right company, I considered two options to build a diversified portfolio while keeping fees low: (1) buying into index funds myself and (2) using “robo advisors” to invest for me. Vanguard funds are particularly popular index funds because they are so low cost. The history of Vanguard is actually pretty interesting. It’s a mutual fund company created in the 1970’s that wasn't designed to earn profits for a management firm. Instead, it redirects net profits to fund shareholders in the form of lower costs.
On the other hand, robo advisors are a recent innovation in the investing space. They provide automated, algorithm-based portfolio management advice and many use ETFs as a primary investment vehicle. The main benefit is that they help you figure out how to allocate your portfolio for much less than you’d pay a fund manager who would typically take 1%+ to invest on your behalf. Many, though not all, have much lower investment minimums than traditional players. Tax loss harvesting to lower your tax bill is also a benefit they frequently offer. The basic idea behind tax loss harvesting is that by selling a security that has experienced a loss and then buying a similar asset to replace it, you can realize, or “harvest”, a loss on the asset while keeping your portfolio balanced at your desired allocation.
Several companies have emerged since the category was created in 2010, many with help from the huge amount of venture money that is flowing into the sector. Some of the largest players include Betterment, Wealthfront, Personal Capital, FutureAdvisor, SigFig, Vanguard Personal Advisor Services and Schwab Intelligent Portfolios. Established players like Vanguard and Schwab are getting into the space with their own competitive offer as this category is heating up.
In the Resources section of this site, I link to a number of articles that highlight the relative merits of robo advisors and can guide you through picking one if this style of managing your money interests you. I have accounts set up with several of these players as a way to actively follow this rapidly evolving space in addition to meeting my investment objectives. With some, I have an investment account, with others I just have a free account so I can asses their offer. On the Tools page, I have listed what has stood out for me so far. The bottom line is that a lot of the offers are pretty similar. One big difference is that some charge a bit more but also give you a person to talk to. In the spirit of taking action, I picked a couple of different players to invest with and just got going.
Lastly, I want to comment on the slight sinking feeling I had when I actually transferred money from my bank account to set up investment accounts. In my opinion, it’s best to avoid this feeling altogether by investing a little bit at a time. I wish I would have been more proactive about setting up small, automated transfers from my paycheck to an investment account a long time ago. That approach has the two benefits. First, you’re not timing the market because you’re investing a little bit over a long time horizon. Second, you stop thinking about the fact that you’re investing if you’re automating things. If you’re in it for the long haul, it’s probably better to ignore short term market fluctuations anyway because they’ll just make you second guess yourself.