I get a ton of emails from readers asking a version of the following question: “I have $X to invest. What should I invest in?”
It’s not a question I can answer with so little context. But I would like to help you answer that question yourself through a series of posts on the topic, and I’ll start with my favorite strategy.
If I pass away and have to leave my spouse and children with one set of instructions as to how to invest, this would be it. I believe everyone should walk through their different investment options carefully before deciding on a strategy, but I suspect this one will represent the best balance of returns, effort required, and ease of understanding and would be the investment of choice for at least 75% of people.
The strategy is this: Invest in low-cost index funds.
What Is an Index Fund?
An index fund is a specific type of mutual fund whose portfolio is constructed to match or track the components of a market index, such as the S&P 500. In general, index funds are generally described as investments that provide broad market exposure, low operating expenses and low portfolio turnover (buying and selling of stocks in the portfolio).
Why Choose an Index Fund?
A low cost index fund such says “I have no idea which stock is better than another.” Instead, it buys shares of every stock in the market in proportion to their market cap, and their whole job is just to mirror movements in the market. Buying a low cost index fund is saying that you are betting on the broad, long-term prosperity of all US-traded companies.
Is this a good bet? History would say so. The compound annual growth rate of the S&P 500 from 1950 to 2016 was 11.27%. The last two years have looked less promising with a CAGR of 8.35%, but still very solid. The compound annual growth rate strongly depends on whether you start in a really terrible year (15-20%+ declines) or not, but over pretty much every long stretch of 20+ years you will see high single digit or low double digit returns.
Of course, past performance is no guarantee of future performance, but it is is one of the strongest indicators an investor can use to get a rough range of what outcomes they might see.
The nice thing about index funds is they tend to be extremely low cost. Because the money manager’s job is just to mirror an index, they can keep costs below, often below .05% a year. That means you, the investor, get to keep as much of the gains as possible.
Current Events Update
When I deploy an investment strategy, I like to think about what if anything about today’s environment will affect my returns differently compared to historical periods. I’ve written a little bit about my prediction of stock market returns here, but you may want to think about your own views and whether the returns adjusted for your views make this still a promising strategy for you.
Overall, I think of a low cost index-fund strategy as still quite apropos for an aspiring retiree in today’s environment.
Key Considerations
An index fund strategy is a long-term strategy, which means you ideally will have at least 10 years of runway to let the strategy do its work. Note that this does not mean if you plan to retire within 10 years that you can’t have index funds in your portfolio, but it does mean you may want to consider an allocation of your portfolio (i.e. less than 100%) that does not require you to sell chunks of your index funds every year to make ends meet.
Some retirees get by flagrantly defying this rule. It really has to do with when and whether you see a downturn – if you retire into a giant bull market, you’ll look at your returns and have no reason to believe that you need to have your money working in the strategy for 10+ years. But if you happen to be the unlucky cohort that dumps your money in right before a downturn where you see real trouble if you were planning on selling chunks of your stocks every year. Fortunately, historical data shows you should still be just fine and generate respectable returns as this unlucky cohort, as long as you don’t pull the money out while it’s down. Those dollars need to stay deployed while the market is relatively attractively priced and poised for recovery. That’s why you should plan to leave the money untouched for 10 years or more; it’s for the situation in which there’s a major downturn and you don’t want to have to sell undervalued stocks just to make ends meet.
Recommended Funds
For the basic strategy, I recommend the following funds. Each pair (Vanguard vs Fidelity) is virtually identical in composition and long-term returns. They are also virtually identical in cost (less than .05% expense ratios).
VTSAX – Vanguard Total Stock Market Return – Admiral Shares
FSTVX – Fidelity Total Market Index Fund – Premium Class
VIMAX – Vanguard Mid-Cap Index Fund – Admiral Shares
FSCKX – Fidelity Mid-Cap Index Fund – Premium Class
Where and How To Trade
There are over half a dozen great discount online brokerage sites you can open an account with to start investing. They are generally all SIPC-insured, which means if for whatever reason the company folks (very unlikely) they have created a consortium whereby your assets will be protected and reimbursed up to $500k per type of account. My current favorite online brokerage is Ally. They’re a large, reputable company that’s been around for a long time (they were formerly known as GMAC). They currently offer the best sign-up bonuses. You can get anywhere from $200-$3,500 in cash bonuses as well as free trades for opening up an account.
If you’re reading this and they’ve discontinued their promos, my other old stand-by is TD Ameritrade; they have a good user interface.
Optimizations
For the avid thinker, there are a million different ways to optimize against an index fund strategy. Some of them can affect your overall returns by several percentage points, which can amount to hundreds of thousands of dollars. Not all indices are created equal. Perhaps you want an S&P index fund over a total stock market index fund. Or perhaps you want the NASDAQ over the S&P 500. Those will take longer to discuss than we have time for in this post but there is a deeper discussion of that here.
One easy optimization to consider right off the bat is to consider ETF’s over their index fund counterparts.
Many major index funds have an ETF – exchanged-traded fund – counterpart. The major difference is that 1) exchange traded funds can be bought and sold intraday, whereas a mutual fund only trades once at the end of each day 2) the Vanguard ETF-equivalents do not have minimum investment amounts to enjoy the advantaged, lower expense ratios of Admiral Shares. More flexibility and less restrictions are net positives to me, so I generally prefer the ETF equivalents (i.e. VTI over VTSAX, VO over VIMAX).
Finally, if you find the thought of considering these optimizations overwhelming, that’s okay. Don’t let the myriad of options paralyze you. Come up with a plan for how much time you want to invest in making a decision, what bar you’d need to hit to consider something unorthodox, then get your research done and pull the trigger.
Conclusion
The low-cost index fund strategy serves as an excellent benchmark for evaluating investment strategies and may in fact be the best choice for your own strategy. Over the next few months, we’ll cover more nuances of this strategy such as different twists based on the same fundamental thesis that offer different risk-reward ratios.
This is a beefy topic. What further questions do you have about this strategy? What have been your experiences? I consider this an opening salvo on the topic and would like to build a post with answers to any follow-up questions. Let’s make this a solid resource for everyone considering it.
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Hi JP, I spend a decent amount of time reading FI blogs, but would like to delve deeper. Do you have recommendations for books that can provide a foundation for understanding investing? I would definitely appreciate a recommended reading list, if you’re willing to create one. Thanks!
Glad you’ve found the site! I’ve added a few book recs here on the recommendations page, and I plan to fill it out over the coming few weeks. I would say once you’ve read 3-4 titles, most of your learning will happen on forums and specialized blogs/sites/discussion groups/implementing your own strategies. That’s actually why it’s been challenging for me to build a good comprehensive recommendations list. I can’t remember where I first found the one article on roth vs traditional IRAs, the forum post I picked up on how options can actually decrease my downside in huge bear markets, etc. Hope that will give you a good start.
Hey JP,
Do you like any particular portfolio (permanent, ivy, 60-40, etc) or would you go with 100% stocks?
This is such a great question I’d like to do a full write-up on it. The short answer is that I like different portfolio allocations depending on whether one is in the accumulation phase or the retirement phase (actually needing ongoing cash flow to fund your expenses). I’m going to assume you mean the accumulation phase, and for that I like 100% equities or 90-10 or 80-20 stock to bond ratio in which the plan is not to keep the bond allocation the same year to year, but to use it as dollars to purchase stocks during decreases of more than 10-15% in the market. I did a deep research project on evaluating the performance of different portfolio allocations’ performance vs 100% equity and have not seen anything compelling. Check out this site for some fantastic data (note: I don’t fully agree with some of the authors’ inferences from the data, but his data visuals are fantastic; he has built a fantastic resource and you can draw conclusions for yourself).
JP, I’ve got a couple of questions for you:
1.a.) What is the minimum amount you would need to invest in these low-cost index funds in order to make a noteworthy difference?
1.b.) Is it something that you can plop $X in to, more-or-less forget about it and, in 10 years, you’re (likely) going to be making money off of it, or are the low-cost index funds something you’re going to want to invest in/tend to on a monthly basis?
2.) Could you share with us your experiences with low-cost index funds?
Interesting questions.
1.a.) Are you referring to a noteworthy difference in your total net worth? I think of all investment as “What is my expected return? what is the risk/probability associated with that? and how does that compare to my next best alternative?” If my next best alternative is to dump it into a 1% savings account, then even $1000 in an index fund makes a big difference in performance. There are some practical considerations to take into account: for example, online commissions cost anywhere between $7-$15 to execute a trade and some of the funds have minimums, but aside from that this strategy is relative passive and so I don’t think there’s much a minimum amount to begin investing. It would be different if you were for example investing in a rental property. Then you’d want it to be a large enough investment as a percentage of your portfolio such that the hours to spend managing it are putting many dollars to work.
1.b.) It’s supposed to be more or less a “set it and forget it” strategy. I don’t like to say completely ignore it as you want to keep an eye on major current events and shifts that may cause you to re-evaluate your strategy, but it’s about as passive as you can get. Often people will make monthly or bi-monthly contributions, buying more shares with their savings from their paychecks, but that’s really deploying new dollars rather than have to “tend” to the existing investment.
2) I will talk about this in more detail in a future post – I have a 70% allocation in low cost index funds right now, with my dollars deployed in many of the funds listed above.
I love index funds, but recently, I’ve tweaked strategy a little. Instead of using the usual broad market funds, I’m gradually moving over to strictly small caps in my Roth IRA. I figure I have 30 years before I’ll even be allowed to touch it, so I can more than ride out the increased volatility. And in theory, small caps outperform other sectors by a few pct points.
Interesting. When you look at the last 30-40 years of data, does it still show consistent outperformance? Is there significantly more volatility? Sounds like it is a nice example of an optimization that uses the same data-based approach.
Hi JP,
I’m glad I found it! I also love reading about personal financial management and would love to get your thoughts on an upcoming scenario for me: I’m going to be selling my Bay Area condo and will net a healthy profit (between 170-200K). This will happen sometime in the next 2 months. I can either:
a) invest that money in index funds
b) buy investment property elsewhere in the US (cheaper areas) and collect rental income
c) Buy an existing website business that already generates income (some sort of retail business or something like that) and manage that/grow that.
I’m leaning toward C because it would enable me to quit my full time job and run my own company, which is something I’ve always wanted to do.
Would love to get your thoughts here!
Hi, I’m interested in investing in mutual funds but I’ve never tried it before. I live in Australia. Can you recommend good Australian mutual funds or how do I invest in mutual funds overseas and in Australia? I’m not sure where to begin.
Hi JP, well it was a really interesting post, thank you for sharing all your experience and knowledge. I want to ask you about the ETF, you said you like when it offers more flexibility and less restricction for example that you can but it and sell it on the same same which doesn’t occur with a mutual fund, So my question is if the ETF offers more flexibility and is an optimization to a mutual fund, does that mean that the ETF carry a quite higher percentage of risk?
My husband and I just created an account with Personal Capital and it is fantastic! We also opened an Ameritrade Account and can’t wait to start investing! We are holding off until we learn more and feel more confident – but we are establishing our foundation so-to-speak. Your articles continue to be really helpful. Thanks!
Great information. What should a teen start investing in? My 17 year old son is great about saving but I would like to get him started in investing. I have tried to stress cash only spending so he is now saving for his next car to pay cash with (he paid cash for his first car also). I think he will be well on his way if I can get him to good financial advisors.
Hi JP,
Thank you for the article. I’m a novice to investing and my question is- how do I know what mutual fund is a low cost index fund? Are they only available through Vanguard and Fidelity? Are there others?
Thank you for the valuable information. Would you know anything about Vanguard’s newest offerings:
Institutional 500 Index trust
Institutional extended market index trust
Institutional total bond market index trust
Institutional total international stock market index trust
Hey Pearl. I can’t say I know much specifically about those funds. If you’re looking for a primer on how to make sense of the prospectus, this article on how to read a mutual fund prospectus might help. Some of the aspects about vetting an actively managed mutual fund won’t apply, but the other basics may be helpful.
I currently invest with Betterment, they use the index fund approach. What are your thoughts on these types of companies?
Hi JP,
What platforms do you usually invest in when you purchase ETFS? I have heard of Robinhood (free), or purchasing index funds through Retirement Accounts such as ROTH IRA or 401K. How about you?
Thanks
Hi JP. I found your blog via yahoo and wanted to ask some questions but had issues contacting you.
1. You saved a lot of money. How much of it was not going out vs having your dates pay for your food/drinks/etc? I’m curious as to what your advice would be for a guy. Obviously, it’s important to save money but how would you balance dating vs saving if you were single and likely to pay for the bills?
2. I haven’t had the change to read your blog thoroughly yet so I apologize in advance if this was already covered. But with your high income and net worth, how do you balance savings vs helping out parents in need (you mentioned growing up in a poor family)?
Thanks!