Fees and Taxes: Like we discussed in the explanation of index funds, high fees are most commonly associated with the active management of mutual funds. Cutting out yearly high fees can earn you tens or hundreds of thousands of extra dollars in your account over the coming decades.
There's really one term that you really have to know: expense ratio. The expense ratio is the amount of money you will pay for the privilege of investing in a mutual fund (including index funds). If I invest $100 dollars in a mutual fund that has a 1.0% expense ratio (which is charged each year) I will pay $1.00 for the right to have my money invested in that fund.
Let’s say you have a choice between a fund with an expense ratio of 1.0% and a fund with one of 0.2%. We’ll assume an 8.0% annual return. If you began investing $500 a month at age 20 in the high-fee fund, you would have about $1.3 million at age 60. Not bad, taken out of context! However, if you had chosen the low-fee fund you would have about almost $1.6 million at age 60. That’s a difference of about $300,000!
A small 0.8% difference in expense ratios becomes a not-so-small fortune when compounded over time. In just the same way, taxes eat into returns over time: like with expense ratios, small costs compound into huge amounts over the years. You’ll want to invest in a tax-efficient way, and we’re here to tell you how to do it! (spoiler: it’s unbelievably easy)
Diversification of Risk: just means 'don’t put all your eggs in one basket.' Buying index funds, like you’ve learned, is one way to diversify away risk. Buying hundreds or thousands of companies means that if one or even several see their stocks plummet in value, your portfolio will be barely affected. However, diversification is more than just buying an index fund that tracks the S&P 500.
Reducing risk is important because though increased risk is associated with increased return, not all risk is simply useful. One can continue to earn respectable returns with less risk and less volatility through diversification. It’s really not difficult, either. To diversify risk, you will invest in index funds that track many different parts of the U.S. economy—energy, consumer staples, real estate, etc.—but also different parts of the world. This kind of diversification is made easy through the ubiquity of index funds and through websites like Wealthfront, which select about a dozen diverse index funds and invest in them on your behalf.
Time: Another way to decrease risk is through patience, which we’ve already discussed. Stocks are volatile in the short run, and you may invest a dollar today that is worth $0.99 tomorrow, or even $0.90 next year. However, stocks tend to grow in value over the long run, and we at WLI, as has become very obvious, enthusiastically encourage investing long term.
Inflation: Finally, understanding the concept of inflation is key. It's an interesting phenomenon because it is both extremely complicated and extremely simple. You've probably heard a politician talk about it negatively and you might've read an article that talks about it positively.
Inflation is essentially the change in prices over a certain period of time. The Consumer Price Index (CPI) tracks the prices of a basket of consumer products: a car, some t-shirts, a hamburger, etc. If the price of the basket of those goods goes up by 3% from one year to the next, then inflation that year is 3%. Right now, in 2016 U.S.A., inflation is close to 0. On average, over the past 100 years, inflation has been about 3% per year. Economists disagree on whether inflation is good or bad, and the general consensus is that it depends: sometimes it's good, sometimes it's bad. But, a little expected inflation is generally thought to be healthy.
Why should you care about inflation? Well, things get more expensive each year. If I have a dollar this year, and a Coke costs a dollar, I can drink a Coke. Great! If Coke increases prices by 3% next year, and I still only have $1.00, I can't afford a Coke! D@mn! If I had saved my dollar in an average savings account, I would've earned interest of just $0.0006. Less than a single cent! I'd still be unable to buy a Coke. But, if I had invested my dollar and received the average annual return of 8%, I'd be able to buy a Coke and have money left over.
Investing is better than saving in a savings account not just because of its higher return, but because of its inflation-beating return. Saving your money is not enough. Your money will actually lose value each year. Investing your money outpaces inflation and grows your money in real terms.
When you read the word real, often in the phrase real return, you should understand that the related number has been adjusted for inflation. If I grow a dollar into $1.02 in one year, my nominal return is 2%, or $0.02 in this case. Nominal means just the number, no adjustments for inflation. If inflation was 3%, my real return would be negative. $-0.01, or -1%. Though I grew my money in nominal terms I lost money in real terms. Important, right?
*The graphs on this page assumes an annual return of 8% from investments in a broadly diversified portfolio of index funds. Returns are compounded annually and, where applicable, inflation is set at 3%/year, following historical averages.