Most people realize money is important for getting what you want out of life—but they don’t want to spend a lot of time thinking about it. The Simple Path to Wealth grew from a blog series Collins subsequently wrote simplifying money and investing for his young-adult daughter. To get along in the world, you need to understand money, he argues. Your options are to take charge of your money—put it to work for you as your “servant”—or be mastered by it.
Of course, everyone has better things to do than obsess about money—for instance, live your life, raise children, make your mark on the world, or enjoy retirement. But ignoring money leaves you open to being taken advantage of by financial advisors who profit from your ignorance by, first, convincing you that you need help, then by selling you complex and costly investments that perform poorly.
In contrast, The Simple Path to Wealth argues that investing isn’t complicated—you can do it yourself. Collins’s “simple path” is: Spend less than you make, stay out of debt, and invest in index funds. If you follow this prescription, you’ll end up wealthy and live a more fulfilling life.
Before starting to invest, do two things:
1) Save until you have “F-You Money,” a financial cushion that gives you the ability to make choices about what you want to do rather than being a victim of your circumstances. For example, having F-You Money allows you to walk away from a job you hate, take a “sabbatical” to do something you dream of, or avoid poverty if you’re laid off.
F-You Money, plus the money you invest for your long-term future, both buy you freedom—and your freedom is the most important thing your money can buy. Ultimately, your goal is financial independence: the point where you can live on 4% of your nest egg a year without having to work for the rest of your life. (Your nest egg remains stable or grows if you withdraw only 4% a year and the market grows.)
2) Get out of debt. While borrowing gets you the latest consumer products, it keeps you from saving and building wealth because your income is consumed by debt and interest payments. Also, debt makes you a slave to your employer: You have to stick with your job, even if you hate it, because you have to make debt payments.
The rest of the book focuses on investing, which requires changing your mindset about money. To build wealth and become financially independent, stop thinking about money in terms of what it can buy and instead think of it in terms of what it can earn.
Wealth accumulation is made possible by compounding, in which money you invest earns interest, and you add the interest to the original sum, making it larger so it earns even more interest. With compounding, a relatively small amount of money invested in stocks grows significantly.
Here’s how it works. Based on the average market return of 11.9% a year with dividends reinvested from 1975-2015:
But you don’t actually have to wait 40 years to achieve financial independence:
To invest successfully, you must understand and accept certain truths about the market:
1) The market is the most effective wealth-building tool ever: Your money should be in the market working as effectively as possible for you as soon as possible. Collins touts Vanguard's VTSAX Total Stock Market Index Fund as the simplest and most effective investment for tapping into the market’s wealth-building capabilities. (Collins notes that he isn’t being paid by Vanguard to promote its funds.)
2) The market always goes up over time: You can predict that it will be higher in 10-20 years than it is today. It’s been on an upward trajectory for 120 years. The Dow Jones Industrial average started the last century at 68 and ended at 11,497 (in 2010). As investor Warren Buffett has pointed out, this period included two world wars, a depression, periods of high inflation, oil shocks, and a dozen recessions and financial panics. Despite dips, the market maintains an overall upward trajectory.
3) The market is volatile: Market crashes (drops of 20% or more) are inevitable—a major plunge typically occurs about every 25 years, plus there are more frequent smaller drops in that timeframe as well as several bull (increasing) markets. There’s always a major crash somewhere ahead—for example, on October 19, 1987, on Black Monday, the market suddenly dropped 22% or 500 points. In addition, even bigger disastrous events like the 1929 Great Depression are part of the predictable process.
4) Investing successfully requires accepting risk and having the discipline to stay the course during downturns: To succeed as an investor, you’ll have to prepare yourself intellectually and emotionally for downturns and tough them out. If you panic instead and sell, you’ll lose.
Investing doesn’t have to be complicated, and you don’t need an advisor to help you. In fact, it’s easier and more profitable for you when you keep it simple. Getting started in investment requires answering three questions and applying three wealth-building tools.
1) What investment stage are you in: the wealth accumulation (income-producing) stage,
the wealth preservation (post-working) stage, or a combination (for instance, you’re between jobs)?
2) What level of risk are you comfortable with?
3) What’s your investment horizon—how many years do you plan to spend accumulating wealth? If you’re just starting your working life, your investment timeframe will be longer than if you’re close to retirement.
These questions are interrelated in that your risk tolerance will correspond with your investment horizon—you’ll take more risk early on and less later as you near retirement. Also, your level of risk and investment horizon will drive your investment strategy. Your job and future plans factor into all three questions. For example, if you’re planning to retire early, you’ll have a shorter investment timeframe, and you’ll want to reduce your risk and preserve your wealth.
The next step after answering the three questions is building your investment portfolio. To do it, you need three tools: a stocks index fund, a bonds index fund, and accessible cash held in a money market or bank account, or a money market fund.
1) Stocks: Collins’s preferred option is investing in VTSAX, Vanguard’s Total Stock Market Index Fund. Stocks give you the best returns over a long timeframe and because they grow in value, they serve as a hedge against inflation.
Index funds like VTSAX are groups of stocks chosen to passively replicate the market’s performance. In contrast, actively managed mutual funds are stocks chosen and managed by professionals who attempt to outperform the market. Collins recommends index fund investing over managed funds because index funds get better results and have lower fees. The chances of anyone regularly selecting stocks that beat the market are minuscule, so you can get better results by buying into an index that contains a lot of stocks that grow steadily over time.
2) Bonds: When you’re nearing retirement, you’ll want to shift some money (about 25%) from stocks into bonds, which are less volatile. Bonds pay interest and counter the ups and downs of your stocks fund. They also serve as a hedge against deflation (declining prices) because in these periods, bonds increase in value. Collins’s choice is VBTLX, Vanguard Total Bond Market Index Fund.
3) Accessible cash: You need accessible cash for expenses and emergencies. It’s also another deflation hedge. When prices drop, your cash buys more. But when prices rise, cash buys less. Don’t keep more cash than you need because when interest rates are low, cash has little interest-earning potential. You can keep your cash in a checking account or a money market account, whichever offers higher interest.
Your two index funds (stocks and bonds) are your investments. Next, you need an investment plan or account in which to hold them. Options include 401(k), 403(b), TSP, IRA, and Roth accounts, which are tax-advantaged accounts.
The government created tax-advantaged accounts to encourage people to save for retirement. The dividends, interest, and capital gains earned by investments in these accounts (except Roth accounts) aren’t taxed until you withdraw the money. There are many varieties of 401(k) and IRA accounts; this section looks at the basic account types.
In an employer-provided investment plan, such as a 401(k), your company hires an investment firm that offers a range of investment options such as VTSAX or other index funds. When you choose funds and contribute, many companies will match your contribution up to a limit. There’s an IRS cap on the amount you can contribute annually; Collins recommends you choose an index fund and always contribute the maximum. Here are some comparisons of features:
TSPs or Thrift Savings Plans are tax-deferred retirement plans similar to a 401(k) for federal employees, including members of the military. TSPs offer five basic types of low-cost funds, including an option that tracks the S&P 500 index.
IRAs are tax-advantaged accounts you hold individually in addition to employer-provided plans like 401(k)s.
Collins recommends that when you leave your job, you roll your 401(k) into an IRA to retain the tax advantage.
When you stop working or retire, a key question is: How much money can you withdraw from your portfolio each year without running out of money before you die?
The common recommendation of 4% a year (the 4% rule) is one piece of retirement advice that actually works. The rule was developed in 1988 by three professors who ran computer simulations to test the impact of different percentage withdrawal rates on various portfolios over a 30-year period. They updated the research in 2009 (adding another 21 years). They found that:
Collins draws the following conclusions:
It’s also important to be flexible—if you can reduce your expenses when necessary, find temporary work, or move to a cheaper area, you can add a layer of security regardless of the withdrawal rate you choose.
The process of withdrawing 4% a year from your investment portfolio is simple:
The Social Security system has been sustainable in the past, but as large numbers of Baby Boomers retire and live longer, the payroll taxes that support it will fall short of payouts if nothing is done to fix it.
Thus, depending on your current age, your experience with Social Security likely will vary:
Although Social Security likely will survive in some form, plan as though Social Security won’t be there for you—that is, follow the simple path to wealth of living beneath your means, staying out of debt, saving F-You money, and investing in index funds. If you get Social Security, it will be a bonus.
If you’re 55 or older, you need to decide when to start claiming Social Security benefits. You can start at age 62, but the sooner you start, the smaller your checks will be. The longer you hold off up to age 70, the larger they’ll be, but you’ll have fewer years to collect them.
Some advisors offer complicated strategies, but as with investing, you’ll be better off keeping things simple. Consider the following in order:
Encapsulating the principles in this book, here is the initial 10-year investment path that Collins recommended for his young-adult daughter at the start of her career:
Collins told his daughter that if she did these things for the next decade, she’d approach financial independence in her early-to-mid-30s.
Once you’ve achieved financial independence and can live on 4% of your investments, continue your career or do something new. If you keep working, invest all of your income (which will increase the amount 4% represents). Consider buying a house, having children, and giving to charity. The reason you save and invest is to create options and opportunities to enrich your life.
Most people realize money is important for getting what you want out of life—but they don’t want to spend a lot of time thinking about it. The Simple Path to Wealth grew from a blog series Collins wrote in response, simplifying money and investing for his young adult daughter. To get along in the world, your options are to take charge of your money—put it to work for you as your “servant”—or be mastered by it.
Ignoring money leaves you open to being taken advantage of by financial advisors who profit from your ignorance by, first, convincing you that you need help, then by selling you complex and costly investments that perform poorly.
In contrast, The Simple Path to Wealth argues that investing isn’t complicated—you can do it yourself. Collins’s “simple path” is: Spend less than you make, invest the extra in index funds, and stay out of debt. If you follow this prescription, you’ll end up wealthy and live a more fulfilling life. The majority of the book focuses on exactly how to invest.
Accumulating wealth requires changing the way you handle and think about money, including:
In addition to spending less, investing, and avoiding debt, you should save until you have “F-You Money,” a financial cushion that gives you the ability to make choices about what you want to do rather than being a victim of your circumstances. For example, having F-You Money allows you to walk away from a job you hate, take a “sabbatical” to do something you dream of, or to avoid poverty if you’re laid off. (The term comes from James Clavell’s 1981 novel Noble House.) Collins accumulated enough F-You Money early in his career to take extended time off work. Later, he was laid off and lived on his F-You Money for three years without a job.
F-You Money, plus the money you invest for your long-term future, both buy you freedom—and your freedom is the most important thing your money can buy. Ultimately, your goal is financial independence, the point where you can live on 4% of your nest egg a year without having to work for the rest of your life. (Your nest egg remains stable or grows if you withdraw only 4% a year and the market grows.)
The more you save and invest, the sooner you’ll have F-You Money and the sooner you’ll be financially independent. Saving and investing half your income is achievable when you learn to live modestly on the other half and don’t borrow.
Financial independence is as much about living frugally as it is about having savings and investments. If you’re laid off after 20-plus years and quickly find yourself broke, you haven’t learned to live within your means. But you can learn to live so that you’re not a slave to money because of your lifestyle and thus, not a slave to your job.
Collins and his family achieved financial independence and retired early by doing three things: avoiding debt, saving 50% of their income, and investing in Vanguard index funds. In this book, he shows you how easy this path to wealth and freedom can be.
(Shortorm note: This summary follows the sequence of the book, but some chapters are combined or omitted to reduce repetition and enhance clarity and focus.)
“F-You Money” is a financial cushion that gives you the ability to make choices about what you want to do rather than being a victim of your circumstances. For example, having F-You Money allows you to walk away from a job you hate.
Do you have any F-You Money saved at this point? Why or why not?
What options would having F-You Money give you? (For example, how would having the financial freedom to do what you want change your life right now?)
How much F-You Money would you need to save to make the options you want a reality? What steps can you take to get closer to meeting this savings goal?
Investing for financial independence requires thinking about money differently, starting with debt. Debt is the biggest obstacle to building your wealth because when you’re making debt payments, you can’t save.
However, debt has become so common in our society that almost no one questions it. We erroneously see it as normal and even necessary for success (many people believe you should incur “good debt,” such as a mortgage). Banks, credit card companies, car dealers, retailers, and others promote debt because it allows them to sell more products more easily and at a higher price because of the interest they charge. At the same time, the easy availability of college loans and car loans has encouraged carmakers and colleges to increase the amount they charge.
Besides not being able to accumulate wealth, when you have debt:
Paying off your debts is simple in concept but difficult in practice. You must significantly scale back your lifestyle and spending to free up money and discipline yourself to stay the course for months or years until the debt is gone.
Scaling back your lifestyle and using the money to pay off debt lays the foundation for financial independence. When your debt is gone, you’ll be in the habit of living frugally, and it will be easy to shift the money you were paying on debt to investing.
Here are the steps to pay off debt:
Collins differs with popular financial advisor Dave Ramsey in advising that you pay off the loans with the highest rates first. Ramsey and others tell you to pay off your loans in the order of their size, starting with the smallest ones first. Ramsey contends that starting small and racking up some successes gives you a psychological boost that motivates you to take progressively bigger steps.
But Collins argues that starting small to give yourself the quickest success is a crutch; you’re adapting your methods to your comfort level. Instead, you should become comfortable with the right strategy: in this case, paying off the loans with the highest interest rate first to save the most money.
(Shortform note: For more on the alternate method of paying off debts, read our summary of The Total Money Makeover here.)
A final word about debt: Be cautious when you hear people talking about “good debt.” The three types most often mentioned are:
1) Business loans: Some businesses regularly borrow for reasons such as maintaining cash flow for expenses, financing inventory, or expanding. Borrowing can help a business keep going smoothly. But it’s also risky—it ultimately sinks many businesses. Using debt successfully requires extreme caution.
2) Mortgages: Many people consider getting a loan to buy a house the epitome of good debt. But beware: The easy availability of mortgage loans a decade or so ago, along with encouragement from real estate agents and mortgage brokers, tempted many people into buying houses they couldn’t afford. This contributed to the 2008 financial crisis.
(Shortform note: For more on the origins of the 2008 financial crisis, read our summary of The Big Short here.)
When striving for financial independence, choose the smallest house that meets your needs rather than the largest house you can finance. Remember, the larger the house, the more expensive it will be to live in: Besides the greater mortgage and interest, you’ll pay more in taxes, insurance, utilities, repairs, furnishings, and landscaping. Further, the money you have tied up in paying the mortgage and building equity is money not available for other things. A house isn’t an investment; rather, it's the biggest expense you can take on. It may or may not be a good financial decision for you.
3) Student loans: College loans trap young people in multiple ways, so do everything you can to avoid them. Students with big loans choose majors and courses of study they think offer the best chance of getting a job so they can pay off their loans, rather than studying what interests them. They’re later stuck in jobs they may not like in order to make the payments. Further, the debt payments eat up money they could be saving and investing for financial freedom. Unlike other kinds of debt, you can’t escape college loans—bankruptcy can’t erase them and wages and even Social Security can be garnished to pay them. College loans basically consign a generation to servitude.
Debt is the biggest obstacle to building your wealth because when you’re making debt payments, you can’t save. If you have debt, Collins advises you to focus your full attention on getting rid of it by following the steps in this exercise.
Step 1: List all your debts, in order of interest rate (with the highest rate first). How much do you pay a month on debt? How does this affect your spending and saving options?
Step 2: Eliminate all unnecessary spending so you can put as much money as possible toward paying off debts. What are some expenses you can eliminate? (For example, what are some things you could pay less for?) How much money do these changes free up per month?
Step 3: Make the minimum monthly payments required on all debts, then apply all remaining discretionary money to paying down the debt with the highest interest rate first. Which debt will you work to pay off first? How long will it take to pay off? What can you do to keep yourself on track to pay it off?
Most people don’t start their working life thinking they will retire as a millionaire, or thinking about becoming financially independent so they can quit work as soon as possible. However, any middle-class wage earner is capable of reaching one or both of these goals by accumulating wealth over time through compounding.
With compounding, the money you invest earns interest, and you add the interest to the original sum, making it larger so it earns even more interest. With compounding, a relatively small amount of money invested in stocks grows significantly.
Here’s how it works. Based on the average market return of 11.9% a year with dividends reinvested from 1975-2015:
This would have happened despite the market ups and downs over that 40-year period, including the 2008 financial crisis.
In terms of achieving financial independence (the point where you can live on 4% a year of your investments):
Many people can’t build wealth because they live a high-consumption lifestyle relative to their income—they spend whatever they make and therefore have no money to save and invest.
Even high-income people have trouble making ends meet or they go broke by overspending. For example, boxer Mike Tyson ended up bankrupt in 2003 despite earning over $300 million—he blew it on fleets of luxury vehicles, Siberian tigers, a 21-bedroom mansion, an entourage of hangers-on, and more.
Like Tyson, many people think of money in terms of what it can buy. If your goal is building wealth and achieving financial independence, you need to think of money in terms of what it can earn. With this mindset, even lower-income earners can become wealthy by limiting their spending and investing whatever they don’t need for expenses.
Even if you overspent in the past, it’s never too late to start thinking differently about money and how to use it. Remember the “simple path” formula: Spend less than you make, invest the extra, and stay out of debt—and you can “buy” your financial independence.
Collins doesn’t argue that you should never spend money, just that you should understand all the implications when you do—including the opportunity cost, which is what you give up when you choose one thing over another.
For example, if you spend $20,000 cash for a car, your opportunity cost—what you give up by choosing to spend $20,000—is the interest or dividends the money could have earned had you invested it. If you invested $20,000 in Vanguard’s VTSAX index fund (more on this fund later), it would earn $1,600 a year or about 8%. That’s your opportunity cost for the first year; over 10 years, because of compounding, you’d miss out on earnings of $16,000 (the amount would have been higher had you reinvested your earnings each year).
Similarly, if you take out a car loan and have to make payments for five years, the opportunity cost is not having that money available to invest monthly and build wealth.
However, once you become financially independent, compounding keeps your nest egg growing while you withdraw 4% a year to spend—so spending has little opportunity cost.
The market is made up of all publicly traded companies that issue stock—when you buy stock in a company, you own a piece of that business. Various indexes, such as the Dow Jones Industrial Average and the S&P 500, use selected stocks as a measure of how the market as a whole is doing.
By investing in index funds, you can passively grow wealth at the pace of the market. In 1976, John Bogle, founder of The Vanguard Group, introduced the first public index fund for investors, replicating the S&P 500. (Shortform note: An index fund is a type of mutual fund containing stocks chosen to replicate the market’s performance. In contrast, actively managed mutual funds are stocks chosen and managed by professionals who attempt to outperform the market. We’ll discuss index funds further in the next chapter.)
To invest successfully, you must understand and accept certain truths about the market:
Truth #1: The market is the most effective wealth-building tool ever. Your money should be in the market working effectively as soon as possible.
Truth #2: The market always goes up over time. You can predict that it will be higher in 20 years than it is today; it will very likely be higher in 10 years as well. The Dow Jones Industrial average started the last century at 68 and ended at 11,497 (in 2010). As investor Warren Buffett has pointed out, this period included two world wars, a depression, periods of high inflation, oil shocks, and a dozen recessions and financial panics. Despite dips, the market maintains an overall upward trajectory.
The market always goes up for at least two reasons:
Truth #3: The market is volatile: Market crashes (drops of 20% or more) are inevitable—a major meltdown typically occurs about every 25 years, plus there are more frequent smaller drops in that timeframe as well as several bull (increasing) markets.
There’s always a major crash somewhere ahead—for example, on October 19, 1987, on Black Monday, the market suddenly dropped 22% or 500 points. In addition, even bigger disastrous events like the 1929 Great Depression are part of the process. Each time there’s a major drop, analysts and pundits proclaim that it’s abnormal, causing many investors to panic and sell. However, even the most alarming downturns are normal.
During crashes or bear markets (those trending downward), remember that:
Truth #4: Investing successfully requires accepting risk and having the discipline to stay the course during downturns. To succeed as an investor you’ll have to prepare yourself intellectually and emotionally for downturns and tough them out. If you panic instead and sell, you’ll lose.
For example, Collins lost his nerve after Black Monday and sold investments. He lost money, not only because he got lower prices when he sold, but also because he couldn’t benefit from the market’s recovery. It took him a year to regain confidence and start investing again; when he did, it cost him more money to get back into the market because stock prices were high from the recovery. From this experience, he learned to stay the course, no matter what happens.
Another mistake is to spread the risk by trying to invest a little in every kind of asset. When you do this, it’s time-consuming to understand various types of assets, determine the right allocation percentages, and track and rebalance your allocations as needed. Further, you’ll get mediocre returns over time.
One way to think of the market’s resilience is to imagine it as a mug of beer. The beer is the companies making up the market, while the foam—the most visible part—is daily prices and hype. You should focus on the beer, the company performance that drives the market higher over time, instead of the froth.
Truth #5: You can’t “time” the market: Financial analysts, pundits, and many investors try to “time” the market—that is, to make money buying or selling stocks based on predicting market performance. They might be right occasionally, but they usually get the timing wrong, buying when the market’s high (prices are high) and selling when it’s low (when they should buy instead).
The same applies to picking individual stocks: Neither the average investor nor the majority of professionals can successfully pick winning stocks consistently. You’re better off investing in index funds with steady returns over time.
Investing doesn’t have to be complex. People selling investments profit by making them complicated—they convince you that you need professional help to understand investment. Yet the actively managed funds they sell are costly and underperform index funds. You can do better on your own. In reality, getting started in investment only requires answering three questions and applying three wealth-building tools.
Every investor must answer three closely related questions:
1) What investment stage are you in? Are you in the wealth accumulation (income-producing) stage, the wealth preservation (post-working) stage, or a combination of the two (for instance, you’re between jobs)?
2) What level of risk are you comfortable with?
3) What’s your investment horizon? In other words, for how many years do you plan to accumulate wealth? If you’re just starting your working life, your investment timeframe will be much longer than if you’re close to retirement.
These questions are interrelated in that your risk tolerance will correspond with your investment horizon—you’ll take more risk early and less later as you near retirement. Also, your level of risk and investment horizon will drive your investment strategy. Your job and future plans factor into all three questions. For example, if you’re planning to retire early, you’ll have a shorter investment timeframe, and you’ll want to reduce your risk and preserve your wealth.
When answering these questions, keep the following in mind:
The next step after answering the three questions is building your investment portfolio. To do it, you need only three simple tools: a stocks index fund, a bonds index fund, and a money market or bank account.
1) Stocks: Collins’s preferred option is investing in VTSAX, Vanguard’s Total Stock Market Index Fund. (He writes that he’s not being paid to promote Vanguard.) Stocks give you the best returns over a long timeframe and because they grow in value, they serve as a hedge against inflation. VTSAX is your wealth-building tool.
2) Bonds: At the point where you’re nearing the wealth preservation stage, you’ll want to shift some money into less risky bonds. Bonds pay interest and counter the ups and downs of your stocks fund. They also serve as a hedge against deflation (declining prices) because in these periods, bonds increase in value. Collins’s choice is VBTLX, Vanguard Total Bond Market Index Fund. (The next chapter explores bonds.)
3) Cash: You need accessible cash for expenses and emergencies. It’s also another deflation hedge. When prices drop, your cash buys more. But when prices rise, cash buys less. Don’t keep more cash than you need because when interest rates are low, cash has little earning potential.
You could put your cash into a money market fund like VMMXX Vanguard Prime Money Market Fund. But while interest rates are low, you’re probably better off putting it in a bank account. Money markets used to offer better interest rates than banks, but currently, bank rates are higher. You can always switch if money market interest rates start rising again.
These three tools—a wealth-builder and inflation hedge, a deflation hedge, and cash for needs and emergencies—comprise a simple, diversified, low-cost portfolio. Next, we’ll further discuss index funds and bonds, then investment strategies and how to determine your asset allocations.
Collins recommends index fund investing over choosing professionally managed funds because index funds get better results and have lower fees. The chances of anyone regularly selecting stocks that outperform the market in the short term are minuscule—you can get better results by buying into an index that contains a lot of stocks (VTSAX covers over 3,700 companies) that grow steadily over time. Yet index funds remain somewhat controversial in the investment industry. Professionals have denigrated index fund investing ever since Bogle introduced the index fund in 1976.
The primary reason for the backlash is that because index fund investing is so simple and low cost, it threatens financial industry profits. As previously mentioned, money managers, mutual fund companies, and financial advisors make big money by charging investors fees, which they justify by making investment too complicated for you to pursue on your own and by claiming they can outperform the market.
Many financial advisors argue that index funds may be fine for average people who don’t want to work at investing, but that with a small effort and professional advice, you can get better returns (outperform the market). However, Vanguard founder Jack Bogle, who died in 2019, contended that in 61 years in investing, he never met anyone who could do this.
In fact, research indicates that only around 1% of fund managers outperform the market consistently, although they’re occasionally lucky. In reality, most professional money managers underperform indexes. Over 15 to 30 years, the index will do better than 82-99% of managed funds.
Before you begin investing, Collins recommends answering three questions.
First, what investment stage are you in: the wealth accumulation (income-producing) stage, the wealth preservation (post-working) stage, or a combination (for instance, if you’re between jobs)? Do you expect this stage to change in the next decade? (If so, how?)
Next, what level of investment risk are you comfortable with and why? How concerned are you about potential market drops, and how would you react to them?
Finally, what’s your investment horizon—how many years do you plan to spend accumulating wealth? How does your horizon affect your views on risk?
How prepared do you feel to begin investing and why? What steps might you take to prepare further?
In previous chapters, we’ve discussed stocks and why you should invest in them. Now, we’ll explore why you should add bonds to the mix.
The difference between stocks and bonds is:
Each bond has an interest rate and term:
For example: A $1,000 bond offering 10% interest and a 10-year term, would pay $100 a year in interest, or $1,000 over the term of the bond.
While stocks and index funds are your most effective wealth-building tool, adding bonds to the mix provides several benefits:
Although bonds are viewed as steadier than stocks, they have several risks:
1) Default risk: The biggest risk is that the bond issuer will default and not pay you back. To help investors determine default risk, bond rating agencies (the primary ones are Standard & Poor's Global Ratings, Moody's, and Fitch Ratings) rate bonds based on creditworthiness. The scale ranges from AAA at the top to D.
The lower a bond’s rating, the higher the risk of default. Default risk is a key factor in the interest a bond pays. Poorly rated bonds are harder to sell, so the borrower or issuing agency offers higher interest to make them more attractive to buyers; investors get more interest when they assume more risk. All the bonds in VBTLX are highly rated, with none lower than Baa, which reduces the default risk.
2) Interest rate risk: Besides default, another risk of bonds is interest rate risk. This is only a factor if you decide to sell a bond before the maturity date (the end of its term). To sell it, you have to offer it to buyers in the so-called secondary market.
Whether you get more or less than you paid for the bond depends on how much interest rates have changed since you bought it. If they’ve gone up, the value of your bond will have decreased because investors won’t want to buy a bond that pays a lower rate. If interest rates have gone down, the value of your bond will have increased and you can get more than you paid for it (it’s a better deal than bonds currently being sold at lower rates). Either way, if you keep a bond until it matures, you’ll get what you paid for it as long as the borrower doesn’t default.
3) Term risk: The third risk factor for bonds is term risk. Along with default risk, the term of a bond factors into its interest rate. The longer a bond’s term, the more likely interest rates will change before it matures, and therefore, the greater the risk it will lose value if you want to sell it. So longer-term bonds pay higher interest than shorter-term bonds. The latter don’t tie up your money as long, so there’s less risk of interest rates changing.
Interest (yield) and terms for bonds can be graphed on a “yield curve.” The bigger the difference between short- and long-term bond interest rates, the steeper the curve. When short-term rates become higher than long-term rates, you get an inverted yield curve, which isn’t welcomed because inverted yield curves are typically followed by recessions.
4) Inflation risk: Inflation (when prices are rising) is the biggest risk for bonds. When you buy a bond (loan money) during an inflationary period, it will be worth less (buy less) when the borrower pays it back. Expected inflation also factors into the interest rate paid on a bond. As previously noted, long-term bonds, which are most likely to be affected by inflation, pay the highest interest. VBTLX reduces the inflation risk for investors because the bonds in the fund have a broad range of terms (the risk is spread out).
5) Other risks include:
The best way to buy bonds is to invest in a bond index fund. Bonds carry some risks, which we’ll explain in a moment, so most people don’t buy individual bonds except for U.S. Treasury Bonds.
Buying bonds via the VBTLX, Vanguard Total Bond Index Fund, mitigates the risks of owning individual bonds because the fund holds around 8,000 bonds, and a problem with one bond won’t have much impact. All of them are high-quality bonds and their terms vary over a broad range.
Now that you know the basics of investing, this chapter focuses on designing your portfolio. Two stages in your investing life determine the mix of assets in your portfolio: the wealth accumulation stage, and the wealth preservation stage. If you answered the three questions for investors in Chapter 10, you have already determined your current investing stage.
When you’re young, you should focus totally on building wealth. In that regard, do two things:
Remember that the stock market goes up and down and discipline yourself to not panic and sell during downtowns. You may want to invest more money during downturns because stock prices are lower, but if you primarily focus on adding regularly to your nest egg over time, you’ll become wealthy.
Investing only in stocks at this point is aggressive but appropriate for the early wealth accumulation stage—it will deliver the greatest return over time. Don’t worry about bonds until you’re preparing to start living on your investments.
When you’ve built your wealth and are ready to retire, your focus should be on preserving it so you can continue to live on it. You want to see fewer ups and downs in your portfolio value, even with the tradeoff of lower overall returns from taking a more conservative approach.
While the wealth accumulation stage is simple—put all your money in a stocks index fund—wealth preservation requires a few more steps:
In semi-retirement, Collins allocates his assets this way:
This is a typical wealth preservation portfolio. You can adjust it to your circumstances: If you want less volatility, increase the percentage in bonds; if you want more growth and can tolerate market fluctuations, boost the percentage in stocks.
Once you’ve determined your investment stage and allocated the desired percentages to stocks and bonds, your next consideration is whether and when to rebalance your portfolio.
Your portfolio’s balance will change as a result of the differing growth rates of various assets over time. You may want to restore your original balance, or you may decide you prefer less risk and therefore want to increase the percentage of your portfolio held in bonds.
If you hold a mix of stocks and bonds, you should consider rebalancing your allocations once a year, or when the market swings 20% or more.
Rebalancing typically requires selling shares in the asset class that has grown (typically, stocks) and investing more in the slower-growth class (bonds). It can be done online with most investment firms and takes only a few hours. Like changing your car’s oil, it’s simple but valuable to do periodically.
To determine what proportion of your nest egg you want to keep in bonds (that is, how conservative you want to be regarding risk), consider the following:
Following are some answers to typical questions about rebalancing toward bonds:
1) When should you shift toward bonds? This depends on your situation and risk tolerance.
Whenever you shift between accumulation and preservation, you should adjust your allocations.
2) Does age matter? It’s more useful to think of life stages rather than age because circumstances may vary considerably among people the same age. However, as your age advances, it starts limiting your options—for example, due to limited physical ability or age discrimination, you won’t have the same employment options you had when you were younger. In addition, you’ll have less time to let your portfolio recover from downturns. These risk factors will influence how soon you diversify into bonds.
3) When should you rebalance? There isn’t a prescribed time, other than avoiding the beginning and end of the year—at these times, the market may be skewed by more people buying and selling for tax reasons. Just pick a time to rebalance each year that’s easy to remember, such as your birthday.
4) How do you rebalance between taxable and tax-advantaged accounts? This can be complicated, but usually you should sell in tax-advantaged accounts like IRAs to avoid taxes. But if you have capital losses, sell in a taxable account because then you’d have a tax deduction.
5) Does portfolio performance improve if you reallocate more frequently? Financial advisors who offer rebalancing as a service argue that it does. However, Vanguard’s research showed that portfolios rebalanced once a year performed only a little better than those not rebalanced at all—so rebalancing more frequently wouldn’t make much difference. Bogle considered rebalancing a personal choice, not one validated by performance data. Collins still rebalances annually.
If you don’t want the hassle of rebalancing, consider TRFs—Targeted Retirement Funds—which rebalance automatically. They cost a little more than a simple index fund that you rebalance yourself, but TRFs are still low-cost. Vanguard offers a series of TRFs, as do other mutual fund companies.
Each fund targets a range of retirement years—you just pick the year you plan to retire and select the fund that applies. All you have to do is add as much as you can to it and arrange withdrawal payments when you retire.
Here’s how TRFs work: Each TRF is a so-called fund of funds. Vanguard’s TRFs contain low-cost index funds, including stocks, bonds, and international index funds, plus an inflation-protected securities index fund. Based on your selected retirement date, the funds automatically adjust the asset balance, becoming increasingly conservative over time.
People differ on whether specific TRFs are too aggressive or too conservative for too long a period. In either case, you can adjust by picking a fund targeted to a different retirement date—for example, if you want a more aggressive allocation (a greater percentage of stocks), pick a fund targeted to a later retirement date.
TRFs are available in many employer-provided 401(k) and 403(b) retirement plans. In addition, interest and dividends aren’t taxed until money is withdrawn.
Previous chapters introduced two life-stage portfolios consisting of two index funds (stocks and bonds) and possibly TRFs. These funds are your investments. Next, you need an investment plan or account in which to hold them. Options include 401(k), 403(b), TSP, IRA, and Roth accounts. There are two categories of accounts:
1) Taxable (brokerage) accounts: Use these accounts for investments that are tax-efficient, meaning those that generate lower taxes than an alternative or none at all. Tax-efficient investments include total market stock index funds that produce low dividends (which are usually “qualified,” meaning they receive favorable tax treatment) and capital gains. VTSAX is a tax-efficient investment: the dividends it pays are small and mostly qualified. There usually aren’t any taxable gains distributions because buying and selling in VTSAX is rare. Taxable accounts are useful because they have fewer restrictions than an IRA or 401(k) on withdrawing your money.
2) Tax-advantaged accounts (which are tax-deferred or tax-exempt): Use these accounts, such as IRAs and 401(k)s, for holding tax-inefficient assets—for example, bond funds that generate taxable interest. Other tax-inefficient investments include actively managed stock funds, CDs, and REITs. They pay interest and non-qualified dividends and produce capital gains distributions.
There are many permutations of tax-advantaged accounts. This chapter looks at the basic account types and their key characteristics.
In employer-provided investment plans, such as a 401(k), your company hires an investment firm that offers an array of investment options. When you choose an option and contribute, many companies will match your contribution up to a limit. There’s an annual IRS cap on the amount you can contribute, with an additional “catchup” contribution allowed for people 50 and older. If you have more than one plan, the cap is the total you can contribute to all your plans combined.
(Shortform note: The maximum annual contribution to a 401(k) or 403(b) in 2020 is $19,500. The catchup contribution is $6,500 if you’re age 50 or over.)
Collins’s views on these plans are that:
Following are the key aspects of basic plan types.
TSPs or Thrift Savings Plans are tax-deferred retirement plans similar to a 401(k) for federal employees, including members of the military.
IRAs are tax-advantaged accounts you hold individually—in addition to employer-provided plans like 401(k)s. When choosing your investment company and your investments (as opposed to employer-provided plans), look closely at the fees.
Here’s what you need to know about IRAs:
Here are the specifics on the different types of IRAs.
The downside is that you have to contribute “after tax” money, or money you’ve already paid taxes on. For example, if you’re in a 25% tax bracket and want to contribute $5,000, you need $6,250, including $1,250 due in taxes.
Here are Collins’s recommended priorities (in order) for investing your money:
Except for the Roth IRA, all the tax-advantaged accounts discussed in this chapter have required minimum distributions or RMDs (mandated withdrawals), starting when you turn 72. If you have multiple accounts (excluding Roth IRAs), you’ll have an RMD for each.
The RMD exists so the government can start collecting taxes on the money you saved. If you don’t make the distribution required, the IRS will levy a 50% penalty; if you only withdraw a partial amount, it will take 50% of the shortfall.
An investment company like Vanguard can set up automatic distributions, calculating the correct amount and transferring it to your bank account, taxable account, or money market on the schedule you choose. Online calculators let you enter your numbers and see what you’ll need to withdraw annually when you turn 72.
On the plus side, your nest egg will continue to grow despite these withdrawals as long as the market increases. However, if you have a large nest egg, RMD withdrawals can push you into a higher income tax bracket. Some people start making withdrawals early to reduce their nest egg and thereby avoid being pushed into a higher bracket once they turn 72. You can put the money you withdraw into a Roth or your taxable account, or just spend it.
If your employer provides a 401(k) or 403(b) investment plan, Collins recommends contributing the maximum amount the government allows, especially if your employer provides a match.
If you have an employer-provided 401(k) or 403(b) plan, what percentage of your income are you investing in it and why?
Are you making the maximum allowable contribution? If not, why? (The maximum annual contribution to a 401(k) or 403(b) in 2020 is $19,500. The catchup contribution is $6,500 if you’re age 50 or over.)
How could you reduce your lifestyle expenses to give you more money to contribute to your 401(k)?
Besides saving for financial independence or retirement, you should also save for out-of-pocket health care expenses. The best way to do that is to open a Health Savings Account or HSA (this is different from an FSA or Flexible Spending Account).
Here’s why you should open an HSA: If you have a high-deductible health care plan, which is increasingly common, you’ll need to have a significant amount of money available for paying the deductible.
HSAs, which are similar to an IRA, were created to enable people to set aside money tax-free for potential out-of-pocket expenses as well as other qualified medical expenses. (Shortform note: In 2020, you can set aside up to $3,550 for an individual and $7,100 for a family each year; if you’re 55 or older, you can add another $1,000 in each case.)
Here are the HSA basics:
This chapter looks at several pitfalls investors should beware of, starting with financial advisors.
Financial advisors include money managers, investment managers, brokers, and insurance salespeople (who sometimes masquerade as financial planners).
As previously explained:
Advisors earn their money in three basic ways, which influence the advice they give to clients.
An advisor gets paid a commission, also known as a load, whenever you buy or sell an investment. For example, major loads are charged for American Funds, but no loads are charged to buy Vanguard funds.
In addition, some funds charge a yearly 1% management fee for the advisors who sell the funds. Because they’re actively managed, these funds carry a high expense ratio and typically underperform low-cost index funds.
Advisors are motivated to put their interests ahead of client interests and push the investments that pay high commissions and management fees. For example, insurance investments such as annuities and whole or universal life pay advisors some of the highest commissions, therefore advisors aggressively recommend them.
The commissions and fees you pay an advisor are typically hidden so you don’t notice them. Further, advisors can make more money by buying and selling investments in your accounts (“churning”) to generate commissions. This is illegal although it can be justified as adjusting your asset allocations.
The second way financial advisors make money is by charging flat management fees, usually 1-2% of your total assets. While this is presented as more “professional” than the commission model, this undercuts the growth of your nest egg and, later, your income in retirement. Your advisor is basically skimming your investment returns, which could have earned you more when you reinvested them.
For example, if you had a nest egg of $100,000, and you invested it for 20 years for a return of 11.9% a year:
Under the AUM model, your advisor’s personal interests can still influence her advice. For example, if you want to withdraw money for a child’s education, she may advise against it because her annual fee will decrease.
Many advisors shun this model because it generates less money for them than commissions and fees. When advisors charge an hourly rate, clients are more time-conscious because they have to write a check for each visit, and therefore are less willing to spend time with their advisor. In contrast, clients don’t notice commissions and fees as much. Still, advisors may charge as much as $200 to $300 an hour.
Paying an hourly rate is the most transparent way to buy financial advice—however, you still have to determine whether the advice is in your best interest.
Some advisors use a combination of these payment methods, making it even more difficult for the client to understand what she’s paying. Rather than trying to find the rare good advisor, you’re much better off going with an index fund that costs you less and returns more.
Besides costly advisors, another pitfall for investors to beware of is the temptation to try to pick winning stocks, or to believe an analyst who says he can.
Analysts study industry sectors and companies to try to predict stock performance. But their predictions aren’t typically accurate because they’re based on companies’ own internal performance forecasts (sales predictions), which are guesses. Further, these guesses are often inflated by managers and CEOs so they look better for Wall Street.
No one can make accurate predictions and pick winning stocks from reading company reports and analyses. Nor can you do so by reading books on valuing stocks like The Intelligent Investor, which was written by Warren Buffett’s mentor in 1949, when there weren’t many managed mutual funds available (so if you wanted to invest, you had to pick stocks). If you’re interested in stocks analysis, the book is worth reading, but it won’t teach you how to consistently beat the market.
(Shortform note: Read our summary of The Intelligent Investor by Benjamin Graham here.)
Buffett is one of a handful of rare exceptions—believing you can be like him is like believing you can learn to box like Muhammad Ali. Anyway, Buffett recommends low-cost index funds for individual investors.
The third pitfall is failing to take full advantage of a windfall. People who find themselves with a lump sum to invest due to something like an inheritance or real estate sale often handle it too timidly. Investing it all at once seems intimidating or risky, so advisors often recommend dollar cost averaging or DCA. Under this strategy, you invest the money in chunks over time, so that if the market tanks, you haven’t lost your whole sum. But Collins opposes DCA for several reasons.
Dollar cost averaging does work for a sustained downturn, but the market is more likely to rise than fall. From 1970 to 2013, it rose 33 out of 43 years, or 77% of the time. With DCA, if the market rises, you’ll miss out on gains and you’ll pay more to buy shares with each chunk you invest.
Other downsides of DCA are:
Instead, do the same thing with a lump sum of money as you do with your earnings:
Dollar cost averaging isn’t the worst thing you can do, but by doing it, you’ll be letting your feelings drive your investment decisions rather than adjusting your mindset so you can make good investment choices.
If you want to avoid being conned, you must understand the following rules:
1) Anyone—even you—can be conned. When you think it can’t happen to you, you make yourself an ideal target. People who think they’re too smart to be fooled are the easiest to con.
2) You’re most vulnerable to a con in the area of your expertise. Con artists look for people who are likely to find the scam appealing—typically those who feel knowledgeable and confident due to ego and let down their guard. For example, many of the victims of financier and marketer Bernie Madoff’s massive Ponzi scheme were financial professionals.
3) It’s difficult to spot a con artist. They don’t look shifty; they look honest, trustworthy, and reassuring. You’ll be more inclined to welcome them than to run from them.
4) Most of what a con artist says is true. The most effective lies are buried in truth or hidden in the fine print.
5) There’s never a free lunch. As your mother warned you, if it looks too good to be true, it is.
Some cons are laughably obvious, like the Nigerian stranger’s offer of millions if you’ll help with a money transfer. Most people can spot these. The pitch that snares you will be more subtle.
Here’s an example of a common investment scam:
Here’s how the scam works. The con artist chooses a volatile stock and sends out 1,000 letters; half predict the stock will rise and half predict it will fall. The half of recipients who got the correct prediction, then get letter #2, and so on, until the con artist ends up with 15 people who received six accurate predictions and are eager to give him their money under false pretenses.
One good way to avoid cons of all kinds is to maintain a simple portfolio of index funds so your money grows without you having to do anything.
The big question when you stop working or retire is: How much money can you withdraw from your portfolio each year without running out of money before you die?
The common recommendation of 4% a year (the 4% rule) is one piece of retirement advice that actually works. The rule was developed in 1988 by three professors who ran computer simulations to test the impact of different percentage withdrawal rates on various portfolios over a 30-year period. They updated the research in 2009 (adding another 21 years). They found that:
Collins draws the following conclusions:
It’s also important to be flexible—if you can reduce your expenses when necessary, find temporary work, or move to a cheaper area, you can add a layer of security regardless of the withdrawal rate you choose.
The mechanics of withdrawing 4% a year from your investment portfolio are simple:
Beyond the mechanics, you should determine some guiding principles for withdrawing your 4%. Here are the principles Collins and his wife adhere to:
Collins’s guidelines for spending money in retirement are:
Adapt these basic ideas to your circumstances. Also, reassess your withdrawal plan once a year while you’re reviewing your asset allocation.
When planning your retirement, you may also want to consider the benefits of giving. In addition to the personal satisfaction you get, giving also has tax advantages.
If you itemize your taxes, you can claim a tax deduction for giving. Beyond that, Collins and his wife created a charitable foundation using the Vanguard Charitable Endowment Program. Under the program:
When you allocate your charitable funds, you’ll have the most impact if you focus on a small number of organizations or causes. Remember to research organizations before you give.
The Social Security system has been sustainable in the past, but as large numbers of Baby Boomers retire and live longer, the payroll taxes that support it will fall short of payouts if nothing is done to fix it.
Thus, depending on your current age, your experience with Social Security likely will vary. Collins argues that:
If you’re 55 or older, you’ll collect the full amount you’re entitled to because politicians won’t take anything away from such a large group of voters. That’s why the solutions proposed so far to shore up the system only affect those 55 and under.
If you’re under 55, you won’t get the same deal, but you’ll still receive benefits. You can expect that:
Social Security is a good deal for most people over 55. Of course, if you invested the 6.2% of your income that goes to social security and the 6.2% your employers contribute, you’d be better off financially in later years. But many people don’t save or invest for retirement, so Social Security will keep them out of poverty in their last years.
You can claim Social Security starting at age 62, but the sooner you start, the smaller your checks will be. The longer you hold off up to age 70, the larger they’ll be, but you’ll have fewer years to collect them.
Some advisors offer complicated strategies, but as with investing, you’ll be better off keeping things simple. Consider the following in order:
Although Social Security likely will survive in some form, plan as though Social Security won’t be there for you—that is, follow the simple path to wealth of living beneath your means, staying out of debt, saving F-You money, and investing in index funds. If you get Social Security, it will be a bonus.
Encapsulating the principles in this book, here is the initial 10-year investment path that Collins recommended for his daughter:
Collins told his daughter that if she did these things for the next decade, she’d approach financial independence in her early-to-mid-30s.
Once you’ve achieved financial independence and can live on 4% of your investments, continue your career or try something new. If you keep working, invest all of your income (which will increase the amount 4% represents). Consider buying a house, having children, and giving to charity. The reason you save and invest is to create options and opportunities to enrich your life.