Why should you be investing?
What do you need to know before you get going?
How and where should you invest your money?
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Knowing: Account Types
Tax Efficiency: Investing in a tax efficient way is, believe it or not, very simple! For young people, the account of choice is the ‘Roth IRA.’ It may sound foreign, but it’s quite simple. Let’s say Smart-Eliza wants to invest a dollar for the long run. She will need to open an account with an investment firm. This could be Vanguard, Wealthfront, Betterment, or many others. You’ve probably heard of Charles Schwab or Merrill Lynch. Doing this is completely analogous to opening a savings account at a bank.
Once Smart-Eliza chooses a firm and opens her account, she will need to choose which type of account to open. This is where we recommend an IRA (Individual Retirement Account). There are two types of IRA: Roth and Traditional. We generally recommend the Roth, but will briefly describe the (few) differences below.
A simple clarification before a little more detail:
Eliza opens an IRA, the IRA is held by an investment firm, some company authorized to invest money on Eliza's behalf. It's similar to the way a bank holds a savings account. Inside of that account, the IRA, Eliza chooses (or the advisor chooses) where the money gets invested.
The arrows show flow of money:
Eliza --> Investment Firm --> Roth IRA --> Index Funds, Stocks, etc.
Roth IRA: Unlike traditional investment accounts, called brokerage accounts, a Roth IRA receives special treatment from the government. When Smart-Eliza contributes that $1.00 to her Roth IRA, she will leave it there for many years. She will withdraw, say, $1.50 when she’s older. Because the dollar was invested in a Roth IRA, Smart-Eliza will not pay taxes on the $1.50.
It may not sound like such a big deal, but as always, a little bit goes a long way. Imagine investing for decades, earning more than $1,000,000, and then having to pay the U.S. Government hundreds of thousands of your dollars! The Roth IRA allows the magic of compound interest to work unhindered. It also excuses the account from being taxed year-to-year, as traditional accounts are.
If Gambler-Ross opened a traditional brokerage account, he would likely buy and sell different stocks during a year. On any profit he makes on those sales, he would capital gains tax. His profits would shrink each year, drastically reducing the magical, beneficial effects of compound interest. If he chose to invest in a Roth IRA, however, he would pay no tax on his profits from buying and selling stocks (though we don't recommend doing that anyway).
Traditional IRA: Contributions to a Traditional IRA, as opposed to a Roth IRA, are tax-deductible. If you earn $50,000 in 2016 and contribute $5,000 to a Traditional IRA, the government will only charge you income tax on $45,000. This is called a tax-deferred account. Imagine again that you are at retirement with a $2,000,000 portfolio. A 30% income tax rate would mean you paying the government $300,000 for each million you saved. Ouch!
Roth IRA: Investors who expect to pay higher income tax rates at retirement than during their investing years should choose a Roth IRA and vise-versa for the Traditional. Don't worry, it isn't one or the other. You could do half-and-half, or create a Traditional account in your 30s after socking away in a Roth in your 20s. For detailed comparisons, click here, or here, or here.
Some extra rules apply to the Roth IRA:
- Because of the incredible financial benefit that this type of account brings, the government limits total annual contributions to your IRA account(s) to $5,500 for investors under 50 years old, and $6,500 for older investors.
- Additionally, an investor can only withdraw money from the Roth IRA if she is withdrawing contributions, not earnings. So if Smart-Lydia invests $1,000, and it grows in value to $1,500, she will only be allowed to withdraw the $1,000. If she takes a distribution of Roth IRA earnings before she reaches age 59½ and before the account is five years old, the earnings will be subject to taxes and penalties unless she uses the money to buy her first home, pay for college education, etc. For this reason, among many others, we always recommend investing money that you won’t need in the short run.
Here's what 40 years of making the maximum annual contribution would look like (blue line), compared to several other choices:
Patience and Thinking Long-Term
Part of following the simple methodology we’re developing together here is learning how to think long-term. You must be smart enough to contribute a little money every month without fail. You must be able to kick back and relax when the market is down, and refrain from changing your monthly contribution. When the market is up and doing well, you won’t sell all your index funds and buy a beach house, and you won’t suddenly double your monthly deposit.
You’ll ride the waves, investing each month, ignoring media hype and tips about ‘sure things’ from your uncle the conspiracy-theorist. You’ll bide your time, relying on short-term money from paychecks, savings, and checking accounts to live and consume now. You’ll keep your hands off your money and let it grow into your later-in-life fortune. Thinking long-term, and being prepared to lose money in the short term, is key. Those of us who patiently stick to our plans are the slow and steady who win the race.
Discipline is taking the bus, not the Uber, and never (god forbid) a taxi. Discipline is using Airbnb or a hostel, not staying at the Marriott. Discipline is saving and investing 10%, 15%, or 30% of your paycheck each month, without fail. Automating this online with your employer or bank will make it easy, and let you set it and forget it so you can move on with your life. Discipline can be increasing your contribution each month, even if just by a few dollars, until you hit the monthly level you’re shooting for.
Discipline is being a rational consumer, ignoring the gross, excessive lifestyles and values that our culture worships, and remaining a down-to-earth human being. Somewhat ironically, you do all of this while becoming far wealthier than anyone who chooses to spend their weekends shopping, dines out at restaurants frequently, or buys brand-new cars with borrowed money.
Without discipline, the info on this site is completely useless! If you are truly interested in becoming financially secure and independent, or even wealthy, you’ll need some discipline. The magic of compound interest is that a little effort today pays off in enormous ways tomorrow. That means that becoming a millionaire requires starting early and saving a few hundred a month, not saving tens of thousands a year and starting late!
It’s not hard, but it takes a little bit of patience and discipline.
You're ready to start investing and start down the road of financial freedom.
Keep rocking and rolling to the final step! Acting: How and Where
Acting: How and Where
You’ve literally reached the final step! Congratulations. You know your sh*t now. Read the rest of this page and get on with your life.
Where to Go, Whom to Trust
We hate fees, we hate taxes. We encourage passive investing and also diversification. We want you to set up easy, automatic, monthly contributions to a Roth IRA, and then get on with your life. So, how do you do it?
We’ve got three websites (investment firms) that we think are the best out there—financially, ideologically, functionally. Two of them, Wealthfront and Betterment, are robo-advisors. Vanguard, the third of the three, is the world’s largest provider of index funds: in some ways a robo-advisor, in others a more typical fund provider.
Wealthfront vs. Betterment
Wealthfront is fantastic for those just starting out. It is considered a robo-advisor, like Betterment, because it has no physical office—it provides an advisory service that is entirely online, from investing new money to tracking your progress. Wealthfront is not a true advisor; its staff will not provide you with budgeting strategies or methods of confronting major financial hurdles. However, even before opening an account at Wealthfront, you will fill out a short, but holistic, survey about your age, income, risk tolerance, etc.
Based on your answers, Wealthfront will suggest an investment strategy for a particular length of time and risk level. You can then review their plan and either stick with it or readjust your risk tolerance. Once you've approved, you transfer your first dollars to Wealthfront, and your money is automatically invested within a few days according to your mutually agreed upon plan.
Wealthfront’s services are free for accounts with less than $10,000. You, as a WLI reader, can get $15,000 managed for free with this link. After that, their fee is a meager 0.25%. Wealthfront is cheaper than its competitor, Betterment, for those with accounts less than $15,000, and equal to Betterment for accounts below $100,000. Remember that Wealthfront has an account minimum of $500, and a kickass app that lets you make contributions and check in on your portfolio’s performance from your phone.
Wealthfront is where we invest our own money in our own personal Roth IRAs.
Betterment has a slightly different fee structure than Wealthfront does. For accounts with less than $10,000 you’ll pay $3.00 a month, or, if you deposit at least $100.00 a month, 0.35%/year. Betterment is clearly more expensive than Wealthfront for these smaller accounts. It becomes less expensive, however, for those with accounts of $100,000 or more, for which you would pay 0.15%/year.
Like Wealthfront, Betterment is a robo-advisor that diversifies your risk, handles asset allocation, and invests in about a dozen extremely low-cost index funds and ETFs that track different sectors of our economy and other parts of the world.
Remember that Betterment has no account minimum, unlike Wealthfront, and has goal-setting capabilities on the website. You can aim for retirement, a road trip, college, whatever, and Betterment will help you invest and plan accordingly for multiple goals. Both Wealthfront and Betterment provide easy to use projections of future account values and, again, have fantastic interfaces. By using this link, you'll get access to special discounts and bonuses by signing up for an account with Betterment.
What about Vanguard?
Vanguard is fantastic for those who wish to reject additional fees altogether, stick with a well-established company, and have a DIY component to their portfolio. Most of the funds in which Betterment and Wealthfront will invest your money are Vanguard funds. So, you could potentially bypass Wealthfront and Betterment, especially after your account grows large enough to incur the (tiny) fees. However, you’ll still pay, as always, the expense ratios of the funds. But remember, with index funds and ETFs, these expense ratios are usually well below 0.20%, which is cheap and fair. With Vanguard, you just won’t be paying an extra fee to the investment firm/advisor, like you would with Betterment and Wealthfront.
One strategy with Vanguard would be creating your own asset allocation, or simply mimicking those of Vanguard or Betterment. You can buy and sell Vanguard funds and ETFs at no charge on Vanguard’s site, at your discretion, which is something other sites generally can't offer. However, the time commitment needed to monitor an investment account and periodically rebalance would be a substantial downside. That problem is what is primarily fixed by robo-advisors.
Another option with Vanguard is to buy a ‘target date fund,’ or TDF. TDFs are funds like any other, but with Vanguard, they invest in funds. They are funds of funds. Say you buy a TDF that has a target date of 2055, which is when you plan to retire. The 2055 Vanguard TDF will split your money into a fund of U.S. stocks, one of international stocks, and one of bonds. As you grow older, Vanguard will decrease the percentage of stocks, and increase the percentage of bonds. This will generally decrease your risk and your returns, making you more securely prepared for the date you plan to begin making withdrawals.
Vanguard is a cheaper option, yes. However, one must reconcile the potential loss of yearly returns by forgoing the allocation and rebalancing services of Wealthfront and Betterment. It’s a choice with no purely quantifiable pros and cons list. Vanguard can be rewarding for investors with a real drive to cut down fees and maximize returns, as well as the time to put the necessary effort into regular rebalancing and monitoring.
Vanguard, finally, is a wonderful research resource. Between their blogs, informational articles and pages, stock analyses, tax explanations, comparative research tools, etc., they are a one-stop site for 99% of the info you might be looking for. It's an incredibly deep and comprehensive site but is also easy to use, which may be more important than anything.
You're done. Congratulations!
And if you’d like to check out other great resources that we eagerly recommend, or access discount codes for tons of sites and services that save you money, click here.
Thanks for putting your trust in WLI. This stuff isn't hard, it isn't unreachable, and it's life-changing. We hope you'll take the lessons seriously, start down your path, and get on with your life, for Pete's sake (and now go help Pete with his finances).
*These graphs assume an annual return of 8% before fees in both the active and passive portfolios. Returns are compounded annually and, where applicable, inflation is set at 3%/year, following historical averages.