I have helped a few people in their early thirties start their savings and investment programs since the start of COVID, and there are some pretty simple principles that make a big difference in getting the results you want. If you follow these basic ideas, then you will be off to a good start.
Surprisingly, many of these basic truths are completely contrary to the advise given by the financial services industry, from banks to financial advisors. Remember that all large financial institutions exist for one purpose only, and that is to maximize the profits that flow to Wall Street. They give us terrible advice, and they encourage us to use a lot of debt, insurance, and investment products that can be ridiculously expensive and even financially ruinous. My favorite resource for investing advice is Warren Buffett. He makes it very very clear that we should stay away from debt and from financial services fees. I encourage every new investor to read Warren Buffett’s annual remarks from the Berkshire Hathaway shareholders meetings, and pretty much anything else he has written.
The first question people ask me about investing is how much they should invest. It helps to remember that you invest your wealth, and wealth is what you have beyond what you require to meet your basic needs. You don’t invest your rent money, or the money you are saving to buy a car in six months. Instead, you invest money that you have or earn that is in excess of what you will need in the next couple of years. If you were to simply leave this money in your money market account, inflation, which is currently running at well over 5% per year, will erode your money’s purchasing power. You would not store your grandmothers silver in an acid bath, and so you should not store your long term savings in accounts that earn less than inflation.
To figure out how much to invest, you need a basic understanding of your financial position. There are two basic concepts here. The first is your balance sheet and the second is your income statement. Your balance sheet is a picture of your net worth at a particular moment in time. Usually it is formatted as two lists. The list on top shows your assets and the one on the bottom shows debts. The balance sheet shows your current financial inventory. At the time of this writing, December 31 offers a great point in time to assemble your balance sheet. Simply write down the balances of all of your accounts, and then estimate the values of your fixed and marketable assets like your car and your house. Do not count things you could not easily sell. Everyone should have a basic understanding their balance sheet before they can make decisions about how much to invest.
The second is your income statement, which you can also call your budget. While your balance sheet is like a photo of a moment in time, your income statement is like video of your month. How much do you earn each month, and how much do you pay out. Your income statement shows all of your sources of income on the top, and all of your expenditures on the bottom. If you have more income than you have expenses, then you generate a little wealth each month. If you have more expenses than income, then you must give up a little wealth each month.
There is a very important concept hiding in here, which is the relationship between your income statement, or budget, and your balance sheet. At the end of each month, you can either deposit the excess into your investment account, or you must make a withdrawal if you are short. So if your budget has a deficit over the course of a month, at the end of the month, you would have to either withdraw money from a savings account, or add to your credit card balance to “make ends meet.” Making ends meet is the challenge faced by so many working families that simply have more expense than income.
A good rule of thumb is that you should only invest money that you will not need for at least two years. So, if you have a balance of say $25,000 saved up, and your deficit is $500 per month, then you will need $12,000 in cash to get to through two years. That $12,000 you need to tuck away somewhere safe where it is readily available to you. The remaining $13,000 you can invest.
Here is the first place you can work in 2022 to really improve your financial position. f you can work on your budget a little bit so that you have a little bit more each month than you started with, it makes a huge difference in your financial position. If you can convert a $500 monthly deficit to $100 surplus, then you can invest a larger portion of your money to start, and you can add to it each month from your surplus.
Let’s compare the two situations where we start out 2022 with $25,000. In the first example, we run a $500 monthly deficit, and in the second a $100 monthly surplus. In the first example, you put $13,000 into the market to start, and at the end of two years, your investment portfolio will be worth $15,730 if you assume a ten percent return. Over the course of the two years, you would have spent the remaining $12,000 to make your budget work. In the second case, you would be able to make an initial investment of $25,000 that would be worth $30,250 at the end of two years, and you would add $2,400 plus the returns on those additions. Close to $35,000 total wealth at the end of two years.
You can see that the monthly deficit will cause you to completely deplete your savings within 5 years, while the slight surplus is quickly moving you toward financial independence. And this is the most important topic. Financial independence. Financial independence comes when you have the freedom to live your life according to your values without financial considerations determining your life. It means you have your life in order so that if you want to accept an invitation to spend three months in Costa Rica, you can do it. Living simply is the fastest way to financial independence.
Let’s sum this up here. The first question is how much should I invest, and that answer is you can start by investing any cash you don’t need for two years, and you can add to this your monthly budget surplus.
The second question is how to invest it. And the first answer is always pay off your high interest credit cards. Anything that charges you more than 10% interest a year is horrifically parasitic. You cannot rely on earning 10% from the stock market every year, but you can certainly guaranty that you are going to have to make those interest payments. The good news is you have a 100% chance of not having to pay interest on debt you pay off, so the impact of paying your credit cards is huge. Let’s go back to our example…
If you have $25,000 in savings, currently earning zero, and $25,000 in credit debt where you pay 18%, and you adjust your budget to have a $100 per month surplus instead of a $500 deficit, then your financial position will improve dramatically. Just the act of paying off the credit card with your balance will net you almost $10,000 in two years. Paying off your high interest debts is your first investment.
Now let’s move on to purchasing investments. We have determined how much we have to invest, and we have worked on our budget so we have at least a little surplus every month, and we have paid off our high interest credit cards. Now what?
Now it’s time, quite simply, to head to the stock market. This is where our old master teacher Warren Buffett really offers the best advice–invest your money without paying fees. Financial advisors hate this advise, because they all make their incomes by charging what are known in the industry as “wrap” fees. In other words, they convince you to deposit all of your assets with them, and then they take a seemingly insignificant little fee of 1 or 2%. Just pennies right? WRONG! These fees eat your savings alive. Let’s say you have a financial advisor who charges you 1.5% on everything you place with them, and then they put you in ETFs or other funds that charge another fee. By the time you get to the bottom of all the hidden fees, you could be paying 2% or 3%!
What does this not sound like so much? Think of this. A long standing rule of thumb is that you can withdraw 3% from your account each year and expect to earn enough on top of that to cover inflation and maintain your standard of living for the long run. If you retire at 65 years old with $1,000,000 in the bank, that means you can withdraw $30,000 per year. That’s it.
But wait… you are paying all of that to your financial advisor! Even if your total fees are only 1%, which is what institutional and ultra high net worth investors pay, that’s a full 1/3 of what you can withdraw each year. Warren Buffett talks about this all the time. You have to compare the fees to what you can withdraw, and you will see that 1% is really 33%, and 3% is really 100%.
What makes this worse is most financial advisors have been stripped of any real ability to help you pick investments. They used to help us pick individual stocks that we would buy and hold. We only had to pay fees in those days, like back in the 1980s say, when we bought or sold stocks. But now, all of the firms use wrap fees and let you trade for free. What financial advisors do now days is create an “asset allocation.” This is where they make a pretty pie chart and invest in different asset classes. You will have a slice of international equity, a slice of domestic large cap, a slice of fixed income, either muni bonds or taxable bonds, and so on. All of these slices come in the form of different funds that all have hidden fees inside them.
Since the early 1990s when the industry really started moving in that direction, the primary method of allocating assets was to first determine an investor’s risk profile. In this methodology, a young person with more income than expenses would be able to take higher risk, and a retired person with fixed income would be lower risk. High risk profiles might be 80% stock and 20% bonds, and low risk investors would be 80% bonds and 20% stocks. And within that risk profile they divide up the pie into different segments. Is that familiar?
But there is a huge problem with this now days, and that’s that bonds are simply not at all a viable investment. They simply do not qualify as an investment at all because they are guaranteed to pay you a return lower than the rate of inflation. (And for those who are going to suggest Treasury inflation protected securities or TIPS, they are selling above face value today, and so they offer no solution) The bond market is a little confusing, because of the math around bonds. Maybe that’s a topic for another blog post, because it could take several pages. But the bottom line is this, when interest rates are near zero, as they are today, then bonds trade at prices close to their face value, which is the principle amount of the bond that is returned to the investor at the end of the bond’s term. That means you could sell the bond today for the same amount it will be worth at maturity PLUS all of the interest payments. In other words, there is simply no reason to wait to collect the money. If you buy a bond today, the sum of all the payments you will receive is no more than you paid, and in the meantime, inflation errodes the purchasing power of the money when you do get it back. This is a terrible deal.
Most financial advisors cannot wrap their heads around this. They they have been so baked in the mold of the 60/40 stock to bond portfolio, that they simply cannot see that the bond part of that equation makes no sense anymore. It just does not.
The only place to put your money right now is the stock market. Period. This is because stocks have earnings and pay dividends and that can increase in value with inflation. Bonds have a fixed face value. A good way to think of this is that stocks have value in real dollars while bonds have value only in nominal dollars. Think of inflation as salt water. Bonds rust in salt water, stocks don’t. It’s that simple. If you have a 6% rate of inflation and 1% in fees, then a bond needs to pay 7% before you even break even. Stocks can go up with inflation.
All this talk of Robinhood and the Meme investor that we read about in the news anymore actually does make some sense. People are fed up with the industry and they want to take control, avoid fees, and make their own trades. There are many many platforms available for this. I refer most people to Schwab to set up their own investment account.
So where do most Meme investors go wrong? They trade stocks like baseball cards, and focus on the market prices of the stocks. This has caused popular stocks to become completely detached from their underlying “boring” fundamentals. Take Tesla as an example. I love the company, I drive the car, I admire that they created the EV revolution, and I think it’s amazing that Elon Musk is devoting his wealth to sending humans to Mars. But the stock? It is currently earning about $3.06 per share each year, and each share costs $1,070. When you divide this up you get a “Price to Earnings ratio” of about 345. Which means the stock value is 345 times annual earnings. I find that people have a very hard time feeling what this means in their bones. PE ratios are easy to glaze over.
I like to think of it like this. How much stock do you need to buy to get a $1 of earning? If you want to buy enough stock to earn $1 a year in Tesla, it will cost you $345. That’s why I own a Telsa, but zero shares of Tesla stock. Let’s compare this to boring old PNC Financial Services, one of my favorite stocks, maybe our largest single position other than Apple. PNC is trading at about $200 per share with earnings of $10.17 per share. The PE ratio is 19.71. Which means you have to pay $19.71 to get $1 in earnings per year. Next look at Verizon, which has been beaten up over the last year. Verizon trades at about $52 per share and earns $5.32 per share each year. The PE ratio is 9.77, which also means that to secure $1 in earnings power, you would have to invest $5.32.
Does that amaze you? You have to buy $345 worth of Tesla to get $1 worth of earning, and you only have to invest $5.32 in Verizon to earn the same amount. Moreover, each share of Verizon actually pays a cash dividend of almost $2.56 per year per share, and a share of PNC pays $5.00 per year. Tesla pays zero dividend.
When you invest in the stock market, you are investing in earnings of a company. We have Social, Environmental, and Governance (“ESG”) requirements in our investments that we use to choose companies to invest in, but when we make the investment, it’s in earnings. We personally choose not to invest in alcohol, weapons and defense, agricultural chemical producers, oil and gas companies, casinos, private prisons, or tech firms that market consumer personal information like Meta and Google. We avoid investing in harmful and parasitic ventures. The only exception is that we invest in Berkshire Hathaway even though they have some oil and gas holdings.
When you pick your stocks, first run this ESG screen so you can be socially responsible. Then invest in stocks that you can buy and hold and profit from the earnings of the underlying company.
What about all the high flying Meme stocks? What about earning 100% in a month on GameStop? Someone will eventually going to be left holding the bag when the selling starts. If you have stock in a company with no earnings, the only way to get your money back is to sell the stock to someone else. The only way to make money is to find a bigger fool. With the federal government literally sending fools checks in the mail, the odds of finding Meme buyers are pretty good…until they aren’t.
Bitcoin is a good example. I don’t know if Bitcoin will hit $100,000 or $1,000,000 or if someone will create a quantum computer that cracks the code and makes the whole bitcoin system fall apart over night. What I do know is that you cannot walk into target an buy things in bitcoins, you have to convert them to dollars first, and that means you have to find someone to buy them. And they don’t actually produce or earn anything. To the contrary, they require huge resources to power the computers that check the transactions, and these costs are paid with more bitcoins. The entire thing is a giant Ponzi scheme.
Suppose the entire stock market blows up and you can never trade another stock. If you own companies with earnings, they will eventually earn your money back for you in real dollars. If you have baseball cards, they will not earn anything. They are only valuable if someone else wants to buy them.
And that’s it in a nutshell. The first step is to find out how much you have to invest. Then open a low cost account, and then invest in good companies that have earnings. If you do this, you will not pay any fees and you will have solid long term investment results. Good luck and please let me know how you are doing.