Investing

What are index funds?

An index fund is a basket of stocks. The basket is usually based on a market index, for e.g. S&P 500 which is basically based on top 500 companies traded on NYSE or Nasdaq. Similarly, we have Dow Jones Index which is a selection of 30 companies in US. An index fund basically has each of the stock based on the market cap of it in the index which the fund is tracking. Let’s say if in S&P500 index Apple has 7% market cap as compared to the total of all the 500 stocks, then every 1$ worth of the index fund will have 7% of fractional shares in Apple stock. So this way you are getting exposure to all companies in the S&P 500 index.

Advantages

1. Risk management/diversification

You are instantly invested in multiple companies across multiple industries with most index funds. This diversification helps you reduce risk compared to buying a few stocks. More the number of stocks across various industries smaller is your risk. You can easily afford to let one of the companies be bankrupt. At the same time you will probably also enjoy the returns from top companies in the index!

2. Self cleansing

An index fund usually doesn’t do any active buying and selling of stocks. The only time a stock position is sold from index is when the company falls of the index. For e.g. if a company goes bankrupt or performs so poorly that it is dropped off the S&P 500 index, that’s when the index also sells shares of that company. In its place a new company shows up and the index buys that company’s stock accordingly. So in this way bad companies are removed from the index and fresh new company is introduced into the index.

3. Low expense ratio

Since the index fund is a passive buyer and seller of stocks and there is no active fund manager that buys and sells stock. As a result of this the expense ratio(fees charged = amount invested* expense ratio/100 ) is usually way lesser as compared to hedge funds/other actively managed funds. This fees includes transaction commission costs, taxes etc and is charged annually. But for index funds usually its cheapest.

4. Takes less of your time

Index fund investing is the simplest easiest thing to do for most people. Doesn’t take too much of your time. Its like set it and forget it. Doesn’t need too much understanding its pretty self explanatory and is proven strategy to invest.

Disadvantages

1. Average/market returns

Since you invest in indexes, you get the index return. If the index went up by 8% in that year, then you also make 8% on your money. If It goes down by 2-3% then even your money goes down by 2-3%. However, don’t be discouraged by average market returns. Most investors loose money and cant even beat the indexes. There was a very famous bet between Warren Buffet and an active fund manager Ted Seides. Between performance of an index fund and an active fund of funds over 10 years. It concluded recently, and as expected Buffet won! You can read about it here.

2. Holding some bad apples/no control over holdings

When you own an index fund with many stocks, most of the times you know a few companies in that fund are performing poorly. Since its an index fund, you cannot do anything about it until the company in question goes bankrupt or gets dropped from the index based on the criteria of index. However, in reality even this is not so bad. Since I mentioned above this is just the process of self-cleansing and eventually you get new companies in the index.

So what index funds to buy?

Buying index funds is one of the best, easiest, simplest, proven strategies for investing. Usually total stock market index fund, bond fund and an international index fund is more than enough. That diversifies you across total universe of companies across the world. Here are some examples from Vanguard & Schwab:

Investing in index fund doesn’t need any understanding of industries, stocks or fundamentals etc. Historically stock market has grown at 8-10% per year. So its just simple math by investing in stock market over long term you are almost getting the same return every year. Makes the whole task of picking stocks to grow wealth easy, less complex. This definitely allows you to focus your time on family and hobbies all the while your money keeps growing. Depending on your age and risk tolerance its better to figure out a what percentage of your money do you want to be in stocks bonds and real estates and then buy index funds based on that. There are also other index funds for different sectors in business, real estates countries etc. Do your research before diving into those and keep an out on the fees.

Disclaimer: I am not a financial professional, and every person’s situation is different. This blog is personal opinion, not financial advice. You should thoroughly investigate and analyze any financial decision yourself before investing any money in any investment program.

An asset from my very first article we know is something that puts money in your pocket. Mostly passively. Simply put an asset class is a collection or grouping of similar behaving assets. They might be similar in terms of how they perform, where they are traded, may be regulated using similar laws etc. As you progress in your financial independence journey, its important to understand different asset classes and re balance depending on your age.

Types of Asset Class

1. Fixed Income Assets

Few examples are things like bonds and certificates of deposits. Bonds are just a loan you give to a corporation or a government entity for a fixed period in exchange for a fixed rate of interest during that time. High quality bonds are usually low risk as compared to other forms of asset classes. Since they have a fixed rate of return, every investor closer to their retirement or based on risk tolerance should have certain percentage in bonds.

2. Equities

Also known as stock or security is a small share in a public company. Buying a share of a company gives you part of earnings the company earns annually. However, this class of assets is much riskier since there is no guarantee on the return on your investment. It can go to the moon or burn into the ground. Having said that, there have been many studies that prove in the long-term stocks are the single best performing asset over anything else.

3. Real Estate & commodities

Real estate can be in form of owning actual property and renting it out to gain money. There are also publicly traded securities called Real Estate Investments Trust(REIT’s) which buy law are required to give back 90% of their earnings to the shareholders. REITs can be companies that invest in data centers and rent them out, public offices, apartment complexes etc. REIT’s usually provide a very high dividend yield compared to other asset classes and are good way to diversify. Commodities can be precious metals like gold and silver etc.

Stocks are the single best performing asset class over a long periods of time

Check out this graph that compares the values of various assets since 1802. See how 1$ invested in stocks grows way more than any other asset class. Bonds grew in value too but not as much as stocks. Interesting to notice is how gold and other metals/commodities barely grew in that time which is a big deviation from what people usually buy gold for. Usually a bar of gold just remains a bar of gold. Doesn’t really grow in value. Also focus on how 1$ bill in 1802 is now probably half of what it was in 1802. This is mainly because of inflation if you remember from our previous article. This just goes onto show that its important to invest and have diverse type of assets to be financially independent and secure your retirement.

What asset allocation strategy to adopt?

With knowledge of various asset classes, how do we go about deciding what is right for us and in what mix? That all depends on one’s own situation, age, goals etc. Ideally one should have a mix of all the asset classes mentioned above in some varying percentages. Since stocks are very risky but usually go up in long term, its better to have more stocks if you are in your 20’s or 30’s since you can take on much more risk. Maybe 90-100% of your investments in stocks. Later in your 50’s and 60’s you might want to have a stable stream of income coming in from your investments and so you might want to have more money in fixed income assets like bonds. It’s essential to not just stick with 1 strategy and mix in your asset allocation. You must re-balance it as you move along in your financial independence journey. It all depends on your investment horizon, risk tolerance. Ask yourselves questions like will you be able to stomach a 30-40% drop in value? Do you have other sources of income? How good is your general knowledge about stocks and bonds and these assets etc.? Then decide  how much money do you want in various types of assets and go on form there. One of the biggest advantages of diversifying among different asset classes is that you reduce your overall risk. Stocks could be in free-fall or may be depressed for 4-6 years but if you have bonds, you could continue to receive income form them during that time.

Let me know if you have any other questions or comments, type them below and I will make sure to reply to them.

So you decided to dip your toes into investing your money to beat inflation and prepare for your financial independence. Not sure where to begin ? Does everything sound too complex and confusing? Well here is a guide that will help you to start your investing journey. This guide details what type of investing accounts exist, taxable, non-taxable and in what order should you go about investing money.

Types of investing accounts

1. Savings account/Emergency Fund

Do not start investing your money without having an emergency account. Investing is a long-term game. Its easily possible you may lose money in short term on paper. Investing needs a lot of patience but over time compounding and a good creates a nice retirement nest for you. Hence its important you have 6 months or more of your expenses saved for emergency. You can try the savings account from my previous post and still get 5% interest to beat inflation.

2. 401K/Employer Sponsored Plans

Many public employers in USA offer to match some % of your annual contribution to a retirement account. This account can be a 401K or a SIMPLE IRA which some employers provide. Examples can be employer matching 50% of your contribution at dollar to dollar up to 6% of your salary. Which means you get 6% more money in your 401K if you put 6% every year!

3. Individual Retirement Accounts

You can contribute up to 5500 USD in IRA accounts per year based on your annual salary and age. A traditional IRA allows you to claim your yearly contributions as tax deductions. You pay taxes after retirement when you withdraw money from this account. Roth IRA’s do not allow you to claim any tax deductions upfront, but you never pay taxes on any gains/withdrawals after retirement. However, these accounts have restrictions on when you can withdraw money and if you want it earlier, you pay penalty to access this money. Self-employed individuals have SEP-IRA which is like IRA’s for employed individuals.

4. Health Savings Account (HSA)

These are new breed of investing accounts. This is an option to you only if you subscribe to a high deductible health plan at work. They are also known as triple tax benefit account. The contributions are tax deductible, money withdrawn to pay for medical expenses is tax free. Any money you have after your retirement can also be withdrawn tax free for daily expenses! So ideally you never pay tax on the money in your HSA.

5. 529 College Accounts

These are investing accounts whose funds are meant to be used for college tuition, books and similar expenses. Most states provide one or the other form of these accounts. There are certain limits on if the money can be used in other places apart from college expenses. Some of these accounts also provide state level tax deductions.

6. Normal Brokerage Accounts

In addition to the above accounts, you can also have an account with any broker. Most brokers today open accounts online and allow you to buy sell securities for free or with some commission. These are usually taxable and you pay taxes on any gains you make when you sell securities in this account. You also have the ability to recognize losses if you have any in your tax returns form this account.

How do we go about investing now ?

• Obviously first you should have your emergency fund saved up!
• Next if you get any match from your employer in a 401K/SIMPLE IRA, I would suggest to make use of that since it’s just free money. Why leave it on the table. Make sure to contribute as much to get the maximum match from your employer.
• Next if you have more money left over, then try going for a IRA account. You can open them at any broker and broker usually tells you to not exceed the 5500 limit based on your profile. IRA usually gives you more options to invest your money than 401K’s.

• Still got more money to invest? Hot damn! Limits on 401k’s per year is up to 18500 USD. If you did not meet this limit in second point then it can be a good idea to contribute more money here. Alternatively, you can even contribute money to 529 college accounts or your HSA depending on your situation.

In Conclusion

The above recommendations are just organized in a way to help you automate your investing/maximize returns and have the least tax bill. As you go on in your life, you do not want to bother about smaller details on these accounts. Most of these investing accounts usually work on autopilot. 401K’s usually only have mutual or index funds as options which you just buy and hold forever. So, it removes the decision making aspect and allows you to spend time on your hobbies or family. The only thing you need to make sure is you are not contributing more than the legal limits allowed per year. For more details on legal limits its best to look on government websites for respective plans.

Do you agree with these recommendations? What type of investing accounts do you use? Let me know in the comments below.