When you first start out investing as a college graduate, or when you've finally been able to get rid of your debt, it can be daunting to know where to put your money, and what you should invest in.
What will give your money the best returns? What investments are lower risk, while still giving you decent returns? What the heck is an index fund?
Today I thought I'd go over some of the basics of investing for the long term, and talk about why it's so important to put your money to work for you – for the long term.
Here's a discussion on the topic of putting your money to work that we had on a recent Money Mastermind Show:
Saving Enough To Have A Self-Reproducing Nest Egg In Retirement
The savings rate in the United States has dropped significantly over the past decades. The Bureau of Economic Analysis shows that if you go back to 1944 the average American was saving 26% of their income. Yes, that was during World War II, a time when people were skimping and saving during exceptional times, but if you look forward 70 years to 2014 our personal savings rate is now just below 5%. On top of that only 41% of Americans are saving on a regular basis. Not enough people are saving for retirement, and when they do they're not saving enough of their income.
The Employee Benefit Research Institute released some interesting figures that show how much the average worker has saved, by age group.
- Workers under 35: Have barely $6,000 in savings.
- Workers aged 35-44: Have roughly $22,500.
- Workers ages 45-54: Have saved just under $44,000.
- Workers aged 55-64: Have approximately $65,000 in savings.
- Aged 65 and over: Have saved about $56,000.
When workers aged 65 and over have barely above one year's average salary saved, something is wrong. The average person just isn't saving enough money to ensure a comfortable retirement.
How Much To Save If You Want To Have A Safe 4% Withdrawal Rate
How much do you need to save for retirement? Obviously it depends on your goals, how much you live on and other assumptions. But if you're like the average person and you want to have about the same standard of living or slightly reduced in retirement, how much you need to save is obviously dependent on how long you have before you retire.
On his site, Mr. Money Mustache breaks down how much you would need to save depending on years you have before retirement. He uses the following assumptions:
- that you'll get a 5% investment return (after inflation)
- you'll live off a 4% safe withdrawal rate after retirement
- that you'll want your nest egg to last indefinitely.
So here's how much you'll need to save depending on how long you have before retirement.
|Savings Rate (Percent)||Working Years Until Retirement|
Keys To Saving A Nice Nest Egg
So what are some keys to save a nice nest egg for retirement? Here are a few.
- Get started early to take advantage of compound interest.
- Use a proven strategy, like buy and hold investing using index funds.
- Keep costs low.
- Automate your investing.
- Sit back and watch your nest egg grow, re-balancing as time and risk tolerance changes.
Different Types Of Savings & Investments
So what are some different types of savings and investments you can put your money into? Let's look at the basics and terminology of investing:
- Term deposit: is a cash investment held at a financial institution for an agreed rate of interest over a fixed amount of time. Typically these types of savings aren't going to net you more than a few percentage points but are low risk.
- Bond: Bonds are a form of debt. Bonds are loans, or IOUs, but you serve as the bank. You loan your money to a company, a city, the government – and they promise to pay you back in full. Low risk, but also relatively low return.
- Stock: the capital raised by a business or corporation through the issue and subscription of shares. Returns can be higher, but they also tend to be more volatile.
- Mutual fund: An investment program funded by shareholders that trades in diversified holdings and is typically professionally managed.
- Index fund: An index fund is a collective investment scheme that aims to replicate the movements of an index of a specific financial market. You get about the same returns as a specified index. Over time tends to be the best returns for most people.
- P2P Lending: Peer-to-peer lending, also known as P2PL is the practice of lending money to unrelated individuals, or “peers”, without going through a traditional bank. A relatively new way to invest, but early returns are promising.
So What Is The Best Strategy For Investing In The Long Term?
So what is the best strategy for putting your money to work investing? In my opinion, buy and hold – investing for the long term.
Buying and holding stocks and bonds for the long term and maintaining a diversified portfolio are still the smartest strategies for the average investor. For the average investor that does not want to spend his life consumed with investing, and who should not spend his life consumed with investing, he should get a nice simple strategy, diversification not only by asset class, that is to say stocks and bonds largely, but by the number of stocks and bonds in each class – a thousand even. So what do you get for that? You get a guarantee that you will get your fair share of whatever returns that the bond market and stock market and are generous enough to provide to us.
Time and again buy and hold investing has shown to beat actively managed returns. That's not to say that in a given year some mutual funds won't outperform the index, but over the long haul – index funds tend to do better.
Alex Benke, CFP® and Rick Ferri, CFA, in the Feb 2014 Journal of Indexes compared an all-index portfolio to 5,000 portfolios of randomly selected, comparable actively managed funds over a 16-year period (1997 to 2012).
What they found was that the “all index-fund portfolio outperformed the active ones 82.9% of the time during the 16-year period. The median annual shortfall of the losing active portfolios was -1.25%, and of those that outperformed, the median outperformance was 0.52%.” Some of their other findings:
- When you combine index funds into a diversified portfolio, they have a higher probability of outperforming actively managed funds – than they do individually.
- All-index portfolios perform best over longer time periods versus for the short term “an all-index portfolio held for 15 years significantly outperformed the average of three five-year periods“.
So if you're investing for the long term, you're likely best off if you invest in a diversified set of index funds, and you do it for the long term.
How To Best Invest For The Long Term
So when the rubber meets the road, what are some of the best low cost ways to invest for the long term? Here are 3 proven methods.
Invest in a diversified 3 fund portfolio
Probably my favorite and lowest cost long term investing method is to invest in something that some have called a 3 fund portfolio. Essentially you will invest in the fundamental asset classes of stocks and bonds, and further breaking the stocks down into domestic and international stocks.
- Vanguard Total Stock Market Index Fund (VTSMX)
- Vanguard Total International Stock Index Fund (VGTSX)
- Vanguard Total Bond Market Fund (VBMFX)
Allocation for this type of portfolio can be determined a couple of different ways.
- Your age in bonds – or –
- Twice your maximum tolerable loss in stocks
Then, once you have you have determined your bonds percentage, some suggest that you put 20-40% in international stocks and the rest in domestic stocks.
Example: If you're 30 years old you could put 30% in bonds (VBMFX), 20% in international stocks (VGTSX), and then 50% in domestic stocks (VTSMX). Read a full article about investing in a 3 fund portfolio.
Invest in a service like Betterment.
If you're lazy like me, and you want the easiest possible solution for investing, you can use an auto investing service like Betterment that will use index tracking ETFs to give you a highly diversified low cost portfolio that invests in thousands of companies.
Not only can you set it up to automatically invest for you every month (meaning you're more likely to invest), but it will automatically re-balance your portfolio for you on a regular basis – something you'll have to do on your own if you invest in a 3 fund portfolio.
It isn't as cheap as the DIY portfolio mentioned above, but it is still a very cost effective way to invest (and one that I use personally!). Check out my review of Betterment.com here.
Invest in a target date retirement fund
Another way to invest for the long term is to invest in a one stop type of mutual fund, for example, the Vanguard Target Retirement 2045 Inv (VTIVX). Essentially these types of funds will invest in other low cost mutual funds, and will re-balance your allocations over time so that you have what they deem as the optimal allocations for domestic and international stocks vs. bonds.
Target date retirement funds tend to have a higher cost than the individual mutual funds, although the re-balancing and portfolio allocation will be done for you.
If you do go down the road of investing in a target date retirement fund, do your best to keep expenses as low as possible, do your research beforehand. They are not all created equal.
Consider Investing In Other Alternatives
If you want to expand beyond investing only in index funds for the long term, there are some other options that are viable, but tend to be a bit more work intensive. Here are a couple:
- P2P lending: Peer to peer lending using a company like Lending Club allows you to loan money to other individuals, while earning interest on the money. My own dabbling in P2P lending has been promising, with returns over 10%. I believe this will become a more common way for people to invest in the long term.
- Real Estate: I haven't invested in real estate, but people I trust swear by buying and holding property for the long term, creating a nice cash flow. Be sure you know what you're getting into if you go down this road. Check out expert sites like this one to get the lowdown on how it works.
Start Investing ASAP, And Stick With It For The Long Term
There are a lot of ways that you can put your money to work for you. You can invest in stocks and bonds, or just deposit your money in a bank at a set rate of interest. You can invest in real estate, or invest in your peers via P2P lending.
When it comes down to it, however, most people are going to get the best returns on their money by investing in stocks and bonds for the long term using a proven strategy like buy and hold index fund investing. It may not be sexy, or get the most headlines, but sometimes slow and steady does win the race.
So h0w are you putting your money to work?