This post is for those earlier in their financial independence (FI) journey who have graduated from a focus on paying down debt, building a small emergency fund and getting any employer 401K contribution match (if you’re lucky enough to get this), and are now faced with the nice problem of figuring out where to invest the extra income each month.
This is typically a time of anxiety. You feel like you’re putting your hard-earned money at risk by investing even though you know you have to. But how to make the right choice? There are so many ways to invest and as we’ve discussed before, too many choices is paralyzing and makes it seem impossible to make the “right” choice.
Fortunately, there is no “perfect” choice in investing. What is most important is that you find a style of investing that interests you so that you’ll learn about it and do it. In this article, I’ll cover some of the main methods of investing including some pros and cons of each. I can’t include (and am not even aware of) many other more niche investing options that can be quite lucrative but I will cover the main categories.
Since this is a FIRE blog, many of the readers will be more interested in investing approaches that are more passive. Many of us actually like managing our finances……yes, we are strange compared to the average person……but given the average person’s finances, that’s a really good thing! However, the appeal of FI is that we can have more of our own time available so most of us don’t want to leave our jobs only to spend all our extra freedom on managing our investments. For that reason, I will start from passive investment options and then describe more active investment approaches.
Step 1 – Learn the Basics
If you are just getting started with investing, it’s critical to learn the basics. Luckily, learning the basics is quite easy. There are several really good books that provide a great foundation on investing, particularly for passive stock market investing using low-cost, diversified index funds. I covered this in some detail in this post.
If you read a few of these books, you’ll see the common foundation in all of them that have led to investment success for millions of people.
But I’m already getting ahead of myself. We’re already jumping to “solution space” as we say in my Dilbert working life. A critical point that is often skipped but that is critical to your investing success, is that you need to shift your thoughts to that of an investor instead of a wage earner. It sounds obvious but I think it’s an important step. What do I mean?
A wage earner thinks about money flowing in return for their effort. Usually this money flows relatively quickly following that effort. You work that month and you get paid for that work that month.
An investor thinks differently. An investor buys assets. They collect assets. They hoard assets. When they have free money to spend, they think about what assets to buy that will make them more money. And when that money starting flowing in, it’s used to buy even more assets that make even more money. That’s how the magic of compounding works. This is how you build wealth.
The time difference here is key. Investing and piling up assets takes a long time. The more you can save, the faster it will happen but the actual compounding from your investments takes a long time. So you are spending money (to buy assets) for a long time, before you see any benefit in terms of lifestyle. You can only start spending the money from your investments much later. If you don’t have the patience, you’ll never build wealth because waiting for compounding requires patience. Your assets need to be left alone for a long time for them to perform their magic.
Note here the key difference among wage earners and investor is the effort part. Earning a wage requires effort. Often an incredible amount of effort. Earning money from your assets requires time but no active effort. You simply need to wait and do nothing. Intellectually we understand this but it feels weird. We are very conditioned around the effort=money paradigm. The investor mindset is alien to most of us but it can be learned.
If you haven’t yet, I suggest reading The Millionaire Next Door: The Surprising Secrets of America’s Wealthy. You’ll find data that shows most millionaires (and most are self-made) are quite frugal. They drive non-luxury cars and have average homes. Some people learn this and get frustrated. What is the point of having money if you don’t spend it on luxuries? If you can’t life the “good” life? The people that get wealthy think differently. They are actually happy without those luxuries (which is very frustrating to those that desire those luxuries!). What they are happy with is their assets that give them financial freedom and security. Why would you want to give that money to someone else to buy things that are less valuable than peace of mind?
Keep your money working for you and generating more money! As an example, if I gain $10,000, I don’t really see $10,000 (and what I could buy with it) anymore. I see a permanent cash flow of $300-$400 per year (3-4% withdrawal rate) that I can have forever. And if I don’t need that money, I don’t spend that either and instead just keep the investment growing. This is how/why the rich get richer.
Another old but good book on the mindset of an investor is The Richest Man in Babylon. It was published in 1926 but the lessons of investing and building wealth haven’t changed much over the years. Although I would challenge you to save a larger % of your income than the 10% advised in this book. The fact that they are trying to push a 10% savings rate seems to indicate that our current low savings rate (5%), at least in America, is not a new challenge in society, although other countries do much better.
Once you can truly start thinking like an investor, growing your wealth becomes natural to you. Instead of spending on things that depreciate, you’ll want to spend your money acquiring assets that make you even more money. Saving money and buying assets becomes habit.
In fact, successful investors usually face the opposite problem of making the mental shift to spend money once they have plenty. Building assets gets addictive and it’s hard to spend money on things that decline in value instead! However, that is the topic of another article. Let’s focus on getting wealthy first and then deal with the problem of feeling ok about spending more.
If you can be disciplined and patient with your investing, the results are quite impressive. Eventually your investments will be large enough that the amounts are pleasantly surprising. As an example, I’m at the point now where quite often the daily fluctuation in my portfolio value is as much as my entire annual stipend during graduate school! It’s a bit crazy to think about.
So, back to the basics. I suggest you focus on two things. This will give you a good foundation as an investor.
- Learn how to think like an asset owner. I recommend learning about stocks as an example. There are many other ways to invest but learning about stocks will help you start to think like a business owner. This is the mindset portion. It’s also worthwhile to really try to understand compounding returns. It’s more difficult than it sounds. Our minds think in linear terms, and it’s not easy to fully understand exponential growth. Just seeing numbers on a spreadsheet is not enough to fully grasp the value of holding onto your assets and letting them work over time. It will take some time and experience for this to fully sink in.
- Learn about the history of the stock market. Again, stocks are just an example of assets. You could look at things like real estate as well but there is a lot more historical information available on stocks and it’s a great asset class to learn that asset values are not static. The point here is to realize that investing in the type of high-return assets you need to build wealth, entails volatility. Your investment values will go up and down a lot over time and you need to become comfortable with that. It’s more difficult than it sounds but learning from history is one of the best ways to become more comfortable with the inevitable booms and busts in asset prices whether you invest in stocks, real estate, commodities, or whatever. A Random Walk down Wall Street: The Time-tested Strategy for Successful Investing is a great book to read for this. If you want to be successful as an investor, you must become more comfortable with volatility than the average person.
Step 2 – Understand your Main Investment Options
I’ll cover the main types of investment options here, starting with the more passive options of each first.
With stocks, you become a part owner in a business. For us little fish, this is a passive investment. You won’t be helping run the company on influence who sits on the board. You’re simply buying a small portion of ownership and in return, you will get a small portion of the profits the company makes. Your returns come from dividends and price appreciation, both of which are paid for by the earnings generated by the company.
As we’ve covered before, the data on investing returns clearly indicates a low-cost, diversified index fund is the best way to have a passive, long-term investment in businesses. If this is all you do, you will do very well over time.
MORE ACTIVE STOCK APPROACHES
There are many options to consider beyond this approach. I’ll briefly cover a few here but except for defining your target asset allocation, I would only encourage you to consider these if you have a very strong interest. These are more expert options where many professionals play and many are zero-sum trading approaches meaning that in order to make money, someone else needs to lose money on the same trade. It’s easy to be on the losing end if you don’t become an expert. Having said that, many people can and do make good money investing this way.
Asset allocation is a key aspect to understand. This is where detailed portfolios are designed using different asset classes in order to maximize returns while also considering risk. This is the heart of the “efficient frontier” where things like an optimum stock/bond mix is estimated. The same analysis is done across other assets like foreign stocks and bonds, real estate, commodities, etc.
Factor investing is a subset of this where persistent differences in returns are used to adjust allocations. For example, small cap and value stocks have had a persistent higher performance than large cap/growth stocks over a long time so many investors will slightly overweight value and small cap stocks in their portfolio.
The main idea of asset allocation is to reduce overall portfolio volatility by investing in assets that move differently (i.e. have a low correlation with each other). Generally this is still a passive investment approach because you determine your asset allocation and then stick with it over time.
Here, investors modify the broad, diversified stock investing approach by emphasizing different areas.
In sector rotation, different industry sectors are overweighted based on where in the business/credit cycle we are in. The timing is different for investing in interest-rate sensitive sectors like finance compared to “defensive” sectors like consumer goods, mainly depending on the credit cycle driven by Fed actions on interest rates.
In tilting, similar to sector rotation or factor investing, the investor emphasizes different asset classes in an attempt to improve returns. Tilting based on valuations is another way to do this.
My personal approach is based on this. I will tilt my portfolio to different asset classes based on relative valuations because the historical data is quite strong on “mean-reversion” in economics which basically means investments that have done really well for a while tend to underperform going forward and vice versa. Usually these changes to my target asset allocation are minor (a few % shift in asset allocations) but if valuations get very different, I am willing to make bigger bets. I also don’t pretend to know the timing. I’m looking for a relative performance boost over long periods of many years without knowing when shifts in performance will actually happen. I’m willing to make changes and then wait even if news is negative and results are poor for many years. This is not very easy psychologically.
Important Note: Many of these approaches sound reasonable but it doesn’t mean they are easy. There is a lot to be said for simply taking a buy-and-hold approach with broad index funds. For example, with sector rotation, each business cycle is a bit different and the timing varies. When something in investing is easy, everyone does it and then any chance at improved performance quickly disappears. For tilting, the timing is also very hard to predict. Some investments over-perform for short periods. Some do so for many, many years. It’s extremely difficult to predict timing accurately. Luckily wall street needs to deliver results quarterly so the little-guy investor can actually have an advantage here.
This is the realm of the expert investor. It’s a much more active and complicated way to invest but many people make very good money doing this. Almost anything can be traded. Options trading. Commodities. Currencies. Active stock picking could be placed in this category as well, including approaches like shorting stocks. It’s well beyond the scope of this to describe these in any detail but if you happen to get passionate about any of these areas, it might be lucrative for you. Generally though, I shy away from trading and focus more on longer-term investing. I want to put my money into things that generate and grow cash over time. I think it’s much hard to be a trader, where you depend on buying something at a lower cost than you can sell it a short time later. It’s much more difficult to do this well and it’s very easy to lose money.
Beyond Stocks, Real Estate is the other favorite investment class that provides high returns. It seems to be a particular favorite in the FIRE crowd. Note that you can’t count your personal house here (unless you rent out a room). The house you live in is an expense, not an investment. To be an investment, it needs to generate cash, not use you your cash on maintenance, upgrades, repairs, and taxes.
The most passive and easiest approach is investing in REITs (real estate investment trusts). Some of these can give a high yield as well since REITS are required by law to distribute 90% of their earnings as dividends.
Direct rental ownership is a much more active approach. You can get a much better return this way but it becomes much more like a job. Many people love real estate and don’t mine dealing with tenants, repairs, property managers, and the transactions of buying and selling real properties. Others like me don’t find this enjoyable at all (I’d rather keep working my current job than do this).
An even more active approach is flipping houses or becoming a real estate developer. But these are full time jobs to make an income through direct efforts, not really an investment.
I consider bonds as something to protect your wealth, not a great tool to build it so I won’t go into detail here as this article is focused on those starting their investing journey and working grow their wealth.
There are many alternative investments you can learn about as well. This is the realm of Ivy league school funds, sovereign wealth funds, and hedge funds. These are special cases requiring large initial investments, specific expertise, and/or very long lock-up times in order to generate their higher returns. However, some are accessible. You could directly invest in things like timber. You could directly invest in the local brewery or bank in some cases. Another example is an MLP (master limited partnership). An MLP makes money on oil and gas distribution and is not based on drilling for more or even the price of the oil or gas itself. Taxes can become complicated and returns are often not as good as they look at first glance but it’s an option. You could become an angel investor, maybe providing some management help with a new start-up as part of your investment. There are many, many more examples.
Luckily though, returns (especially after fees) seem to be comparable to much less complicated and accessible investments so it’s not necessary to invest in these type of assets to get a good return. My advice is to skip these and focus on stocks and real estate funds at least to start.
FOCUS ON YOUR FAVORITE
Since there are so many options, it can get overwhelming, so my advice is to focus on the basics, including the mindset, of investing by learning about stocks. Invest in low-cost, diversified index funds with your extra cash. If that is all you do, then you will do well with your savings.
As you advance, you may get more passionate about investing and decide to branch out into other areas. If you do, spend the time to learn and become immersed. The people that make money in more complicated areas only do so by becoming specialists. You could find it becomes an enjoyable and financially rewarding side job but it will certainly be more work than a passive index fund approach. You will need to become and expert but if you do, you could earn better returns. The choice is yours.
Finally, if you tinker with more risky investing approaches, play with a smaller amount of your savings, especially if it’s risky. No more than 10% of your total assets is a good rule of thumb that many follow.
Regardless of how involved you get in investing, if your goal is financial independence at a relatively young age, you will need to learn about investing. Even if you are a bit intimidated or even bored about the thought of investing, my advice is to embrace it and dive in. Most people that do find it to be very interesting and enjoyable. If you’re smart about it, you’ll certainly find it financially rewarding.