Growing up, my parents routinely, consistently, repetitively, constantly, all the time (you get the gist?) stressed two things: the power and importance of a great education, and the power and importance of compound interest, Vanguard Index Funds, and always spending far, far less than you earn. (They also told us to be good people and do good things for the world, but that’s not pertinent to this post.) For better or for worse, I internalized their advice. Until now, however, I wasn’t able to put such financial advice to work.
Since leaving school, I’ve invested considerable amounts of time into studying compound interest, Vanguard Index Funds, and the importance of one’s savings rate. I check investing books out of the library, subscribe to numerous blogs, and read Money Magazine and Fortune online. I’m no expert. But I now know enough to fully embrace my parents’ weird obsession with Vanguard Index Funds, which is why I was truly surprised by what happened early this week when Tanner met with a financial adviser.
Two weeks ago, Tanner received a promotion and a raise. It was really nice. Even better, it meant that he was now able to contribute a portion of his salary to the state of Maryland’s 401k program. Accordingly, he met with the 401k adviser to hash out the details. In this meeting, the adviser showed him all of the options and made her recommendation. Here came the surprise: She recommended the TRowe Price fund, instead of a Vanguard fund, because the TRowe Price funds showed a better past performance than Vanguard. Even though TRowe Price had much higher expense fees (more on this later), she felt it was worth it because its past performance indicated the fund would likely outperform Vanguard in the future.
This advice, as I mentioned, flies in the face of everything I’ve read, heard, and learned. Warren Buffet, Mr. Money Mustache, my parents, the head manager of Yale’s enormous endowment, famed investor John Bogle, and many others, all preach the virtues of Vanguard because (a) low fees, more than anything else, are the most important thing to look for in an investment and (b) Vanguard has the lowest fees of anybody. However, since this woman was an investment advisor professional who certainly knew far more than I did, her advice made me doubt myself. So, I devoted almost an entire evening to re-reading all the stuff I’d read before and determined she was giving bad advice.
And then this morning, a financial blogger came out with a post about the really bad investing advice his girlfriend received from her financial advisor. The post described how it’s financially advantageous for financial advisers to push their clients into the funds that are most profitable for the adviser (or more accurately, for the company the adviser works for) instead of the investor. Aha! I thought. Now this was getting interesting.
But I’m getting a little ahead of myself. There are three simple rules to investing well: (1) save as much money as possible once you start working; (2) invest in index funds instead of actively managed mutual funds; and (3) invest in the company with the lowest management fees (almost always Vanguard).
Your Savings Rate Matters Early On
Compound interest is powerful. You achieve compound interest once you start earning interest from money you earned from previous interest. If you put $100 in the market, and the market luckily returns 20%, you’ll have $120. If the market returns 20% again in year two, you’ll earn that 20% interest on $120 instead of just the original $100 investment. You’ll be reaping the benefits of compound interest—the $20 in interest you earned in year one earns you more interest in year two. At the end of year two, you’ll have $144 (the $120 you had after year one, plus 20% of that $120, which is $24). And, even when the interest rate goes below that 20% rate in the future, your total keeps building from there. Compound interest is pretty cool, right? The earlier you start investing, the more times your money compounds.*
To make sure you’re saving early, you have to be smart. You know, avoid expensive cars (or all cars. bike! walk! take the bus!), expensive houses, frequent dining out, cable, huge cell phone bills, and Starbucks. Avoiding these things will leave you with plenty of cash to spare. If you invest this excess money well, you don’t need to work long, or have a huge salary, to build up an investment big enough that you can live off the fund’s proceeds. This means that (ideally) your fund will be earning enough compound interest that you’re able to withdraw a small percentage of the fund each year, while the fund continues to grow and thus never runs out.
Invest in Index Funds
There are many different ways to invest. You can buy individual stocks (shares of Apple, for example). You can buy individual bonds (US Government-issued bonds, for example). You can buy an actively managed mutual fund. You can buy a passively managed mutual fund. You can buy an index fund. Definitions are needed, so here goes:
A mutual fund is a collection of stocks, bonds, and money market accounts (cash). Thus, if you invest $100, you’ll have a nicely balanced investment portfolio of stocks, bonds, and cash.
An actively managed mutual fund is a collection of stocks, bonds, and cash that uses a paid money manager—a real live human being—to try to beat the overall stock and bond markets. So if you buy the an actively managed mutual fund, the investor running it tries to sell the stocks performing well before everybody else in the market does the same thing. These cost more to run because analysts running the fund are buying and selling every day. Thus, they charge higher fees.
A passively managed mutual fund is a collection of stocks, bonds, and cash which does NOT try to do better than the overall markets. Instead of having the investor routinely buying and selling, the company simply puts your money into the different markets and lets it sit there. If the market goes up, your account goes up. If the market goes down, your account goes down.
An index fund is a certain type of passively managed mutual fund. It matches its proportion of different investments to an actual index, such as the S&P 500, the Nasdaq Index, international stocks, the small company index, or others. Because it’s passively managed, it rarely buys and sells; it ebbs and flows with the market. And because it’s supposed to proportionally match a pre-set index (hence, “index” fund), they’re pretty easy to run.
Many financial advisers try to convince clients they should invest in actively managed mutual funds. This makes sense because the adviser believes the company analysts are good at what they do, and the company makes more money when you invest in actively managed funds because they charge higher fees. But almost always, regardless of what your financial advisor thinks, financial analysts can’t beat the market. (Research demonstrates this: read this, this, and this).
Ignore Past Performance; Look for Low Fees
It makes intuitive sense that if an actively managed index fund has done well in the past, it’s going to do well in the future. But this is usually deceptive; what this history means, in reality, is that an investor had a lucky streak of picking good stocks for a while. Moreover, even if by some strange miracle, the manager of the fund actually can beat the market, there’s no guarantee that manager stays with the fund. Managers move from company to company and fund to fund all the time.
Perhaps most damningly, it’s very rare for an investor to actually get the actively managed fund’s advertised return. While a fund may boast of high returns, research shows that actual returns for an individual investor in a technology based actively managed mutual fund, for example, can be as much as 13.4% lower than advertised.
Morningstar (the independent rating agency who rates each fund based on its performance) conducted a study and found that the best indicator of a fund’s future performance is not past performance. Instead, the best indicator of a fund’s future performance is actually the amount of fees it charges: “Investors should make expense ratios a primary test in fund selection. They are still the most dependable predictor of performance.”
A “fee” is what the company charges each person to manage the money. Actively managed mutual funds charge from 1.5% to 2% of the total amount of money in the fund, per year. The fees are charged, even if the fund didn’t grow at all, or lost money. 1.5 or 2% doesn’t sound like much, but if the fund has a bad year and doesn’t grow at all, losing 2% of the fund could really hurt your investment. Vanguard’s index fund, in contrast, charges a fee of .17%.
Now we get to the crux of my parents’ advice and the nefarious nature of Tanner’s financial adviser’s recommendation. Vanguard charges the lowest fees. It should always be your first choice for that reason alone. TRowe Price’s past performance in no way means we should pick it over Vanguard.
Thus, in conclusion, don’t listen to what the financial adviser says if they try to push you toward an actively managed mutual fund or an index fund with high fees. Instead, pick out an index fund in your company’s 401k program. Go with Vanguard, or whatever company has the lowest fees. You can contribute up to $17,500 tax free. Invest monthly to take advantage of the regular highs and lows of the market. Once you’ve maxed that out, if you still have more to invest, open up a Roth or Traditional IRA through Vanguard. Invest the maximum $5,500 in an IRA index fund. After you’ve maxed out the tax-advantaged 401k and IRA, if you still have more left over, invest the rest in a regular Vanguard index fund. Then just let the money sit there for at least seven or ten years.
It seems appropriate to end with Warren Buffet’s investing advice. Every year, he releases a letter to the shareholders of his company. In this year’s letter, he told his shareholder what he put in his will concerning the management of his wife’s money. Does it sound familiar?
“Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. I suggest Vanguard’s. I believe the trust’s long-term results from this policy will be superior to those attained by most investors…”
*Let’s say, for example, you want a million dollars by age 65. The market averages a 7% yearly return (says Warren Buffet). If you invest only $293 every month from the age of 20 to 65, you’ll get a million by 65. If you wait to start investing until the age of 45, you have to invest $2,032.74 a month to get to a million by 65.