DIY Investing 101 (US) — Why bother learning about Investing?

Learning to save and invest is a fundamental building block to shape your life into what you want it to be. Most people want to build a rich and meaningful life for themselves, but few take the time to understand the building blocks of creating long term wealth and freedom.

You may ask, “Why should I do all this work and bother building wealth in the first place?” Why can’t I just enjoy my life spending as I go without creating long term wealth goals! It is a very valid question.

The way I argue for consciously attempting to build wealth and aim for financial freedom is by pointing towards the word “freedom”! Building substantial net worth frees you in more ways than one. When you don’t have to worry about living from paycheck to paycheck, when you are sure that your dependents will be fine if something were to happen to you, when you are assured of not having to ever struggle to make ends meet in your retirement years, when you are not even a little bit worried about losing your job anymore, when you have the capacity to contribute generously to the causes you may care about; — it raises your game to a whole new level!

Freedom has been known to reduce stress, enhance creativity and provide us with an overall sense of well-being. It allows us the mental space to ask questions like “Am I doing the things that I do only for money or is there a larger theme to the projects I am contributing my time to.” “What else do I want to do in my life?” Questions like these are likely to lead to more meaningful pursuits and more productive structuring of your time and effort. To me, such an outcome is well worth the efforts we will put into achieving financial freedom!

Lets look into nuts and bolts of learning how to invest well in US! I have tried to create a simple template for understanding the basics and then formulation a plan of action.

Investments come in a wide variety of choices. Think of these choices as being part of a spectrum that has Low risk and low but guaranteed return investments at one end (think CDs, savings accounts, government bonds) vs High Risk and high but not guaranteed returns at other (think highly speculative stocks, IPOs, risky corporate bonds and cryptocurrencies). In the middle is everything else with moderate risk levels.

Financial Freedom 101

The most important thing is to start as early as possible. With Investing we can harness the tremendous power of “compounding” that grows exponentially with time! To visualize this let us take an example. Let’s say you start investing at age 25 and invest $1,000 each month for next 20 years and then retire at age 60. Alternatively, let’s say you start at age 35 and contribute same $1,000 for 20 years and then retire at same age of 60. Who do you think will have a larger pool at retirement? Can you guess by how much?

Let us assume return on investment is 9% per year for both. (Assuming slightly lower than long term S&P 500 total return which is around 10%)

If you had started at 25, you would have approx. $2,432,760. But if you start at 35, you would have just $1,027,630. See the difference compounding can make over time! Despite contributing the same amount of money ($240,000) the results are drastically different if you start few years earlier! Also note that at retirement, most of the 2.4 million that your 240K has turned into is “growth” (90%)! Compounding over time is the biggest superpower any investor has for accumulating substantial wealth!

Before we get into the details of various investment options available, let me first tell you a story about stocks and bonds!

Naisha (we have met her earlier!) wants to quit her job and start a business of her own. It would be a company focused on providing cyber security training to various businesses and institutions. She has saved some money that will help her cover some expenses, but she needs more money to get established and hire more staff. She has basically two choices. One is to borrow the money from family/friends or a bank. Other choice is to “sell” a portion of ownership of her company to friend, family member or any other interested buyer. Then the buyer will have ownership over that fraction of her company’s all future earnings. She can also do both of these things and raise money both ways. Lenders in this case will have first claim to the money she makes to pay off interest and loaned amount, equity owner will get his portion of what is left after paying off all creditors. (that is why we call equity ownership as “residual” claim on the assets of a company)

If she borrows money, she must pay it back with agreed rate of interest. From the perspective of the investors (providers of money), ownership stake (stock) is riskier than the loan to her business (bond). Hence an investor will only be willing to make an equity investment if he/she gets a higher rate of return than the bond (to justify taking higher risk).

These two choices that Naisha had are really the two fundamental types of investments — equities and fixed income (debt) that form the foundation for most of the investing options we have.

1. Equities and Mutual Funds

We will restrict our discussion to publicly listed and daily traded stocks only (and mutual funds that hold such stocks).

One of the greatest feats of modern finance (modern portfolio theory in particular) has been the idea of looking at and evaluating all our investments as a group rather than in isolation separately. Expected risk and expected return are measured at the portfolio level and one tries to maximize the return given the level of risk he/she is comfortable taking at the portfolio level. This all sounds great in theory, but how do we put it to work?

What this implies is that each stock in isolation is “extremely” risky. One can easily lose “all” the money invested in that stock since some companies routinely go out of business. But a group of companies is unlikely to go bankrupt at the same time. So, investors try to “protect” themselves by investing into “groups” of stocks that are diversified in various sectors of the economy.

Since it is hard (and time consuming) to pick a diversified group of stocks, most people elect to invest via mutual funds that are essentially groups of stocks sold as a single fund (and can be bought/sold daily).

Mutual fund charge fees of course (called management fees) and one must be mindful of these fees when selecting funds. Since these fees are deducted from the fund value directly (as against being paid separately) a lot of investors seem to be unaware of the level of fees they are paying. One can easily find the annual fees in the fund prospectus (they are usually in the range of 0.03% to 2.0% of your investment each year).

There is a mind-boggling variety of funds on offer, and one must be careful to select these. One should also avoid sales charges (called fund loads) and buy share classes that do not have these loads attached to them.

A simpler type of funds on offer are indexed mutual funds (or ETFs that track the index) that charge very low fees and simply buy all the stocks that make up an index (for example Total Stock Index or S&P 500). I strongly argue for owning these funds rather than funds that actively pick stocks to buy and are expensive. One in this case would get the return that the index will provide. A lot of recent research has made it evident that it is extremely hard, even for seasoned investors to beat the market returns over long periods of time. When higher fees charged by actively managed funds are accounted for, the probability that an active manager will beat market index returns (net-of-fees) over long periods of time is very low! As per the SPIVA scorecard that tracks the active vs passive performance, it is abundantly clear that over a 15-year period, benchmarks have outperformed almost 90% of the actively managed funds!

And then one must also consider the probability that the fund/manager “you” will select will turn out to be a manager capable of beating the market in future. (since the past performance of a fund is not a good predictor of whether it will continue to perform well in future as well)

Even Warren Buffett and Peter Lynch (who are arguably the best stock pickers of our times) seem to agree:

“Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals.” ~Warren Buffett, Chairman, Berkshire Hathaway

“All the time and effort that people devote to picking the right fund, the hot hand, the great manager, have in most cases led to no advantage. Unless you were fortunate enough to pick one of the few funds that consistently beat the averages, your research came to naught. Thereʹs something to be said for the dart‐board method of investing: buy the whole dart board.” ~Peter Lynch, Legendary Manager of Fidelity Magellan

A lot of times our vanity comes in the way of making sensible investments. We all want to pick the greatest stocks and funds and then bask in the glory of how awesome our investments turned out to be even when the low-cost index funds may be a more sensible choice for most of us!

Burton Malkeil (Professor at Princeton and author of “A random walk down the Wall St” has the following analogy:

“It’s true that when you buy an index fund, you give up the chance to boast at the golf course that you picked the best performing stock or mutual fund. That’s why some critics claim that indexing relegates your results to mediocrity. In fact, you are virtually guaranteed to do better than average. It’s like going out on the golf course and shooting every round at par. How many golfers can do better than that? Index funds provide a simple low-cost solution to your investing problems.”

2. Fixed Income (Bonds)

A problem with stocks (even groups of stocks) is that they can go up and down in value based on market conditions, thereby making your portfolio suddenly lose a lot of value (i.e. they are volatile).

To protect against this volatility, investors add some risk free (or close to risk-free) securities to their portfolio. (example CDs, government bonds or highly rated large company bonds) These tend to steady the ship and give some protection from sudden swings.

Usually the younger you are, the longer is your investment horizon (the period for which you do not need to withdraw the money) and hence you can invest more in the stocks and less in the bonds. As one grows older, it is considered prudent to shift towards bonds and towards less risky investments. A general rule of thumb is to own your age in bonds, meaning that someone who is 30 years old should have 30% invested in bonds). When the same person is 50 years old, he should be 50% invested into bonds and rest in stocks and other forms of investments.

Of course, these are only general rules of thumb and people can deviate from these for all sorts of personal reasons, risk tolerance and sometimes tax considerations.

Here again the total Bond index funds (or equivalent ETFs) are a more sensible choice than actively managed funds. Since most investment grade and government bonds guarantee a specific rate of return when held to maturity, and to pay extra to a manager for investing into investment grade government/corporate bonds is simply a waste of money since the manager is unlikely to add any significant value net-of-fees over time. Here again around 90% of the funds were outperformed by the benchmark over last 15 years!

3. Real Estate

In last 21 years (Jan 2000 to Oct 2021), in the 20 large cities of US, home prices have increased at an average rate of approximately 5.26%. This is only price return and does not include the any “Net Rental Yield” (i.e. rental income property will generate net of property taxes, HOA (if applicable), maintenance and insurance costs) To estimate Net Rental yields, we need to know the price to rent ratio prevailing in a location and property taxes rates (these vary a lot from location to location). Net rental yields generally range from 3–7% depending on location/costs and property prices.

Pay attention to the “Cost” of Investing (fees)

Most investments incur some sort of investing fees that can be direct or indirect. Direct fees are more evident for example trading fee charged by your brokerage provider, any maintenance fee, property taxes and closing fees for real estate. Since these fees are paid directly, these are quite easy to spot and account for while evaluating investments.

But the indirect fees such as those charged by mutual funds are harder to measure and understand. Mutual funds directly deduct fees from the funds’ net assets, so for example if you invest $ 200,000 in a mutual fund that has an expense ratio of 2%, it means that it will charge 2% of your investment every year as fees. So, $4,000 which will be your annual fee deducted directly from your invested value. As the fund increases in value, the absolute fees amount you will pay will also increase, for example if fund grows to $300,000 in a few years, you would then be paying $6,000 in fees per year!

What Long term returns to expect (and how to spot too good to be true returns)

All of us would sometimes come across investment opportunities that seem to make promises of “guaranteed” return of a seemingly high rate! We should be very skeptical of any such guaranteed high return scheme. High return investments are by definition very risky (no borrower would willingly want to pay out a higher return if he can finance at a lower rate). “Guarantees” do not mean anything unless the entity making the guarantee is extremely credit-worthy and creditworthiness itself can change with time.

The right way to think about the risky return rates is to start from risk free rates. Anything that has a government guarantee is deemed to be risk-free.

• Risk Free rates — US Treasury 1 Year — 30 Year is the range 0.38% to 1.96% (as of Dec 29, 2021). This is the risk-free rate available in US right now depending on the investment period.
• Certificate of Deposits, CDs — (0.7–1.4% depending on duration and bank). These are also FDIC insured up to a limit of $250,000.
• Risky Investment “Expected” returns: Since right now the risk-free rate is in the 2% range based on above available investment options, one would only make a risky investment if he/she expects a rate higher than these rates.

Since there is no easy (or even hard!) way to predict future returns on risky investments, history is the only realistic guide we have. Past returns US stock market proxy, S&P 500 return including dividend payments has been (from the available measurement period of 1926–2019) close to 10% annually with high volatility (total return). Government bonds in the same period yielded around 5.5%. Even though the percentages do not seem different, stock market return in long run would have a dramatic impact on wealth due to compounding over time.

10,000 USD invested in 1929 would have turned into at the end of 2019:

• 1,238,002 in Government Bonds
• 53,130,226 in S&P 500!!!

So, the annual return rate from S&P 500 over this period should set a reasonable upper limit on our expectations from any risky investment. Anything above this rate is not to be “expected” from our investments, and even this rate is only achievable over the “long-run” since stock markets are volatile and may lose value over a few years. Any strategy that “promises” to outperform this long-term S&P500 average must be evaluated with a lot of skepticism.

Allocation (How to pick investments in your 401K, IRA, Roth IRA and Taxable accounts):

Now that we have a sense of key investment options, we can proceed to define an Investment strategy for the long term based on the following key ideas.

• The younger we are, the longer investment horizon we have. (and hence more the equity exposure we can undertake.)
• We do want some fixed income (bonds) exposure to steady the ship, and this exposure will be increased the closure we reach to retirement. (No one wants to have their net worth drop by 30% the year they want to retire — if it happens to be the year of a steep market crash!)
• In long periods of time, stock market as a whole is not that risky as it may seem year-on-year. There has been no “20 year” period in the history of S&P 500 that it would have lost value and ended in red. Even if you invested at the “height” of dot com bubble in 2000, you would still make a decent return by now. (given that you would not have panicked and sold at loss earlier!)
• Since we make money gradually, the best way to invest is to invest regularly as you get paid. Trying to time the market is not a game an investor with long term horizon should play! This approach to investing is called “dollar-cost averaging” where you invest equal amounts periodically regardless of the market levels. This has the added benefit of buying more “units” when the valuations are low and less units when valuations are high!
• Low cost and broad-index tracking passive investments are the simplest and best bets in long term where no active manager is likely to outperform except by chance!

DIY vs Target-Date:

Depending upon how much your time and attention you wish to allocate to the process of managing your investments, there are two good alternatives available.

I will discuss the easier hands-off approach first that will be suitable for most people who do not want to actively select investments and have other more important uses for their time. This approach is in no way inferior to the DIY approach but will cost on an average 20 to 25 basis points more which is not a lot considering the time savings.

Hands-off Target Date Retirement Index Funds Approach:

All one needs to do is select a reputed Target Date Low Cost Index Retirement fund and invest into this fund in all your investment accounts. (eg. Vanguard Target Retirement 2050 Fund (VFIFX) for those who are planning to retire around 2050.) Most good retirement plans will have an equivalent/similar target-date low cost indexed retirement plan.

Internal composition for such a 2050 fund will be (or at least should be) something similar to the below (in 2021).

Retirement 2050

This proportion will change year by year slowly increasing the fixed income portion as retirement age comes closer to reduce risk. All this happens automatically and is done by the target fund manager and the investor just needs to contribute in a timely fashion.

DIY — build an Indexed portfolio:

It is actually not very complicated to build and maintain an Investment portfolio built from Index funds but does require some work and your 401K plan must offer the component index funds that can be bought.

• Define equity vs fixed income allocation suitable for your age and comfort level.
• Define whether you wish to invest only in US stocks or want to build a global portfolio. Most people these days opt to have a global portfolio.

Let us take a simple example to illustrate:

Suppose Naisha who is 25 years old (in 2021) and hopes to retire before age 65 (i.e. around 2060) wants to build her own retirement portfolio using broad-based index funds available in her 401K plan. Since she has a very long time-horizon before she retires, she feels comfortable allocating large fraction to US and international equities. She finalizes the below allocation for simplicity:

Simple DIY Portfolio

Since these ratios will change over time depending on returns on these three funds, Naisha also decides to rebalance once a year when she receives annual bonus. Using the bonus contribution into 401K she should be able to rebalance without selling existing positions in most scenarios. This will restore her allocations back to approximately 50–30–20 each year. She also decides to increase her Bond allocation every 5 years by 5% and reduce stocks by the same amount so that by the time 2060 arrives she will be 60% invested in bonds allowing her to draw a stable income if she chooses to in retirement!

How much will I need to retire?

If you are like most of us, you have probably not even thought about retirement yet! Forget about trying to estimate how much will you need to retire! But since most of us work on jobs that will not offer any pension, the need to build up a retirement corpus is critical and non-negotiable (unless you are expecting a huge inheritance)!

Naisha being the personal finance savvy person that she is! She uses a retirement calculator to determine what retirement corpus she should attempt to build if she wants to retire at age 60 in and wants to withdraw $100,000 pre-tax dollars per year (assuming all her retirement funds are pre-tax). She assumes she will live up to be 90! So, she needs this income for 30 years!

She also expects to get a monthly social security check of about $1,800 per month as per her recent annual social security statement. This assumes that she will be employed in US for a minimum of 10 years for social security retirement benefit to kick in and will continue to work in US until retirement. Also, the SSA retirements benefits for those born after 1960 do not start until age 67. It is also beneficial to wait until age 70 to claim these benefits since Social Security Administration incentivizes this by making your benefits 124% of the eligible monthly amount.

For the moment I will just assume her social security benefits to be a uniform 20,000 per year for simplicity throughout retirement. (since she will not get anything until age 67 and will then get more than 20,000)

Any guess about how much do you think she will need in her retirement accounts at age 60 to last her 30 years with annual withdrawals of $80,000 from Retirement accounts and approximately $20,000 that she will get via social security checks?

Actually this question does not have a precise answer (except if she chooses to place all her money in cash uninvested and just withdraws 80,000 every year drawing it down to zero in year 30. In this case she needs 80,000*30 = 2,400,000 or 2.4 million!). But in reality, she will have this money invested conservatively and there will be some growth. So as per simulations run by Vanguard for future returns, she will need around 2.0 million at retirement to have a greater than 90% probability that her money will last 30 years! This 2 million number just gives her a bare minimum target that she absolutely needs to save up to for her retirement. She will of course need to pay taxes as she withdraws, and hence actual in-hand money will be 100,000 less any federal and state taxes.

Since it is probable that she may live to be 100 years of age, she will need to save even more so that she does not outlive her money! She may also want to leave some inheritance for her future kids! So, all this will go into the calculations of setting her actual goal for retirement savings that may be much larger than 2 million. For example, if she wishes her money to last 40 years instead of 30 and she wants at least 500K left for inheritance at her death, she should be targeting around 3.0 million!

For sake of simplicity I have not made any cost of living adjustments that her income will need to undergo if she wishes to maintain same standard of living in retirement factoring in inflation. This will adjust the target sum further upwards! Also, in retirement, most of us will have a paid off home that will be ours and will be available for living and then selling if we wish to or leaving it to our heirs! But keep in mind that property taxes, insurance and maintenance expenses will need to be paid until our death from our own retirement funds.

Creating a portfolio:

Knowing all this, how should one go about designing a portfolio suited to himself/herself? The key principle is to keep things simple and having the discipline to stick to that strategy over long periods of time.

Following steps are all that is needed to put this in action:

1. Set aside some savings in a high yielding savings account. (at least 3 months take home salary)
2. Maximize 401K contributions to fully utilize Employer match and tax deferral.
3. Examine how much more can you realistically invest. Let’s say you have $2,000 more to invest each month after meeting monthly expenses. This leaves you with around 24,000 post tax dollars to invest annually. Out of this 6000 (2020 IRS limit for Roth IRAs) should go into the Roth IRA account where it can grow tax free indefinitely. In case your income is more than allowed for Roth contributions, you should consider doing an IRA to Roth IRA rollover that is allowed.
4. If you have kids or dependents who would study in US in future, next bucket to fill should be a 529 account. Let’s say you place $10,000 in a good 529 plan. This money will also grow tax-free indefinitely but can only be used to pay for eligible education expenses (tuition, boarding, books, laptop etc)!
5. Once these tax-advantaged buckets are exhausted, only then you should consider investing via a taxable brokerage account. Remaining 6,000 annually can be invested via this route.
6. Review once a year and rebalance if necessary.

That’s it! You are setup! Just keep investing every month regardless of the market going up or down. Trying to time the market is a loser’s game. Over long periods of time, stock markets always return positive returns greater than bonds. (otherwise these markets would not exist, and everyone would just buy CDs and bonds)

A note about periodic stock market crashes!

Stock market crashes happen every few years and no one can predict when they will happen. The only thing we know for sure is that in long term, stock markets generate best risk adjusted returns over-all.

We should never panic sell in these down markets. Markets rebound after each crash and if we have a long investment horizon, there is no reason to worry about these downswings that create opportunities to invest even more at lower valuations! These downswings trigger “fear” in us causing us to take reckless decisions like selling in falling markets and stopping our regular investments, thereby deviating from our investment plans. We should never give in to these emotional reactions and the high-pitched shrieks of news anchors announcing doom and gloom. Markets will return to health once the crisis passes as they always have!

Good luck!