By now, you should have:
- A working budgeting system for both your personal and business expenses.
- Six months living expenses saved between your personal emergency fund and your business retained earnings.
- No non-mortgage debt.
- An LLC or S Corporation
- Monthly payroll
We've come a long way, baby. Before building our mansion, we had to lay some foundation. By now, you're probably wondering how we got halfway through the book and are just now getting around to actually doing any wealth building. It's not exciting, but successful wealth building is more about creating efficient cashflow into your investments than it is about your investment strategy.
With advances in financial instruments like the low-cost broad market index fund, your investment strategy is made extremely simple:
- Decide on your risk tolerance.
- Buy low-cost funds to reflect that tolerance.
- Periodically change your holdings to reflect your changing tolerance.
The Most Elegant Investment
Everyone's heard the mantra that it's important to diversify our investments in order to reduce risk and maximize real returns. Enron employees found this out the hard way back in October 2001 when many had their entire retirement savings in their company's wildly overvalued stock. Don't bet everything on one horse.
Because of this, personal finance gurus recommend using investment vehicles called mutual funds. These funds are corporations (kind of like yours!) that pool the money of investors like you to buy and sell securities to produce diversification for you. Fund managers speculate on which companies will produce the highest returns for their investors.
However, most actively managed mutual funds are structured in a way that the owners of the mutual fund company are separate from the investors in the mutual fund. What this means is that it's in the fund manager's best interest not to make you money on your investment, but to make the owers of the fund rich from the fees you pay to invest.
Let that sink in. You're sending your money to a company expecting them to make you more money, but it's actually more important to retain you with the hope of making returns than it is to make the returns, since you're paying high fees so the fund manager can choose your investments for you.
- Investing is a zero-sum game. There are no winners and losers in the end.
The author of the classic index investing book A Random Walk Down Wall Street, Burton Malkiel, had this to say about what an index fund could do for the average investor:
What we need is a no-load, minimum management-fee mutual fund that simply buys the hundreds of stocks making up the broad stock-market averages and does no trading from security to security in an attempt to catch the winners. Whenever below-average performance on the part of any mutual fund is noticed, fund spokesmen are quick to point out "You can't buy the averages." It's time the public could.
...there is no greater service [the New York Stock Exchange] could provide than to sponsor such a fund and run it on a nonprofit basis... Such a fund is much needed, and if the New York Stock Exchange (which, incidentally has considered such a fund) is unwilling to do it, I hope some other institution will.
Risk and Behavior
Diversification and Costs
Maintenance
Creating an Investment Plan
I cannot stress this enough: Your single worst enemy in long-term investing is yourself. Because money represents our life energy, we become emotional when we gain or lose a ton of it at once. Throughout your investing lifetime, you'll make huge gains and suffer enormous losses. There will be moments you wonder whether the market will ever recover, and others where you'll feel the rush of a huge gain turn toward the edges of greed.
That's why it's critical you have, in writing, a plan for your investment strategy. It should outline your target savings rate, which investments you will buy, and how you will behave once you buy them.
Here's mine:
Financial Plan
This financial plan is a commitment to my personal financial goals over the coming years in order to ensure I don’t panic and stay the course.
Savings Rate
Maintain at least a 30% savings rate. If you dip below a 30% savings rate for longer than six months, reduce lifestyle in order to change that.
If you want to plan to buy a house, feel free to allocate 100% of your savings rate toward a down payment for a period of time. Because of your hight savings rate, this lull in investment shouldn’t be a problem.
Funds
Invest in the following funds, exclusively:
- VTSAX - Vanguard Total US Stock Market
- VGTSX - Vanguard Total International Stock Market
- VBMFX - Vanguard Total Bond Market
Rebalancing
Rebalance asset allocation once annually on January 1, according to the following scheme:
- Bonds %: Age - 20
- Stocks %: 100 - Age + 20
Behavior
- You will not sell any of your equities, except in these scenarios:
- You are selling to rebalance based on the rebalancing scheme described above.
- You are selling to finance your living expenses during retirement.
- You are selling because of an emergency and after having exhausted all other options.
You will continue to maintain a high savings rate, regardless of your income level. If your income drops, you will reduce spending to maintain that savings rate.