Investing 101: How to Start Investing the FI Way in 2024
This Ultimate Guide on How to Start Investing aims to take out a lot of the mystery/unknown variables for beginning and advanced investors alike. The mantra is to make your money work for you. There are so many technological and psychological tools that will help you on your journey to investing well on your journey to FI.
We believe in the long run. Life is the long run. So, your finances should follow suit. We'll discuss elementary and advanced investing techniques. We'll also dive further into more complex investing. These concepts will include stock market conditions, investing strategies, and how to best round out your portfolio. The FI way.
Some of our approaches on how to start investing are different from other articles you may find online. That's because we believe in giving you a specific toolkit for the long-run mindset. So, when we start talking about assets of non-liquid value (e.g. precious metals, real estate, Bitcoin), you'll be prepared. We'll also include tips on how to capitalize on automation tools to keep as much value as you possibly can. Nothing is TL:DR (Too Long: Didn't Read) here at ChooseFI. We, like we live our financial lives, believe in creating value and not fluff.
What Is Investing?
Investing, in short, is making your money work for you. Easy, right? Well, it can be simplified (which is what we believe in here at ChooseFI); however, learning how to start investing can still be intimidating. We all have an emotional connection to the money we work so hard for. Putting your money at risk in order to create anything from small returns to wealth holdings can be harrowing.
Using some poetic license, Lancey Howard from the hit 1965 movie The Cincinnati Kid, said it best:
"It is a pleasure to meet someone who understands that to the [true investor], money is never an end itself; it's simply a tool, as language is to thought."
Money NEVER is an end itself. Yes, it does hold value. Yes, you can spend it to get shiny new things. But, we want you to be financially prepared for life.
History and Evolution of Investing
The history of investing, relevant to modern-day investing, began with the Central Banking System (those "dead Presidents" notes when they were backed by gold) and the distribution of wealth through the industrial age. Corporations started their charters and the stock market opened on Wall Street. Anyone with currency could start investing in different companies and yield a rate of return OR lose it altogether.
We hear those FI-ers out there who know their history shouting: "What about the Great Depression of 1929?" Good question! Because "trading" and "investing" on speculation of increase was so lucrative and a win-win, corporations began to sell shares of their stock "on margin." Selling on margin is when you pay a small fee up-front to receive the full-face stock value up-front (usually this was 10% of face). This created a massive demand for stocks; buy on margin, sell for a little more than you paid for it.
Black Friday
We just strolled down memory (well, history) lane when the stock market was a so-called "win-win" situation for traders and corporations alike. Well, we all know that in a capitalist society, this model isn't sustainable. On October 25, 1929 – the bubble popped, sending the U.S. economy into a free fall. Traders and their brokers could not fulfill their margin call (see "Important Terminology") obligations. Thus, began the most significant economic downturn in U.S. history. You can read more about the 1929 Stock Market Crash here.
Regulations and Changes to the Market
We won't bore you with all the specifics of the laws and regulations created as a result of the market crash. What you do need to know is that the stock market evolved into an economic marvel post-WWII. America became the wealthiest nation in the world. With that wealth, Americans invested in corporations and other financial trading options en masse. Big Banks started offering "micro-investing" – which is a fancy way of saying savings accounts and certificates-of-deposit.
As we moved into the '80s, Savings and Loans opened their doors. Credit Unions followed. The takeaway - we all know what happened during the Savings and Loan crisis: insolvency due to over-lending. Also, the housing market crash in 2008: credit default swaps. Don't let history repeat itself. How do we do that on a personal investing level? Two key concepts: diversification and investments (not day-trading; solid, long-run investments).
Don't worry, we'll give you some sage advice on how to make the best decisions.
But, first - here are some key investing concepts and acronyms you need to be familiar with.
Investing Terminology and Explanations
ETF: (Exchange-Traded Fund) is a bundle of securities that are bought and sold throughout the day. These are above-average trading assets because of their low cost, relatively high liquidity, and diversification within the funds.
Compounding Interest: interest that accumulates and is capitalized (added to the initial balance) at a defined period. You are paid interest on your investments and the interest gained. This creates the ability to exponentially increase your investment over time.
Dollar-Cost Averaging (DCA): an investing strategy that reduces the volatility of an asset swing. Designed to mitigate loss and cost by purchasing assets at a fixed dollar amount over a fixed time period.
Diversification: allocating different financial assets across your portfolio to mitigate risk and capitalize on positive market changes. These are weighted determinate on the investor (risk-averse v risk-tolerant).
Health Savings Account (HSA): a triple-threat tax advantage healthcare savings account. An HSA has the ability to save thousands in taxes utilizing its unique structure.
Margin call: occurs when the value of an investor's margin account falls below the broker's required amount, requiring the investor to add additional funds in order to avoid forced liquidation.
Robo-advisors/investing: utilizing apps (e.g. M1, Robinhood, Stash) to purchase financial assets. These apps utilize complex algorithms and forecasting models to create the best “bang for your buck” given your risk allocation.
Return-On-Investment (ROI): a simple mathematical formula that calculates your percentage return on investment. Expressed as: Net Profit / Investment Cost x 100.
Risk-averse: inherently taking a stance against risk; being conservative with your investments.
Risk-tolerant: usually willing to take chances with risk; being more aggressive with your investments.
Stock Chart: a snapshot of a stock’s current price, trending price, lowest offered price over time, highest price offered over time (for FI-ers, the Trend Line is what we will focus on).
The Trinity Study: a landmark market study published in 1995 by 3 finance professors from Trinity University (San Antonio, TX). Defined the 4% rule of retirement by studying 70 years of market data.
Traditional IRA: an individual retirement account (IRA) that is very similar to a 401(k) with a couple of key differences. A Traditional IRA consists of pre-tax dollars and grows tax-free within your account. However, these financial vehicles are not employer-driven. Further, you can only contribute per annum about half of what you can into a 401(k). Finally, IRAs are usually where 401(k) monies flow into when an employee leaves an employer - making them naturally, but not mutually, inclusive.
Utility: economic terminology for the satisfaction, enjoyment, or usefulness someone receives from consuming or utilizing a good. Only in theoretical terms can it be quantified. So it is primarily used to express qualitative differences (example: I receive more utility from chocolate ice cream than vanilla ice cream).
401(k): the most popular retirement plan offered by employers. Employees, dependent on the rules of their employer, contribute 1-6% of their pre-tax dollars to a mutual fund or similar financial asset (potential options are selected by the employer from which employees choose). The employer then matches your contribution (anywhere from 50%-200%). This is a triple threat: it reduces your income tax burden, “free” money is given to you by your employer, and interest is tax-deferred until you are ready to retire (59 ½ years).
457(b): a retirement account offered to state and government employees. Similar to a 401(k), pre-tax dollars are contributed to a mutual fund or an annuity. Where they differ is if you decide to take retirement before 59 ½ the 10% penalty is waived. This makes this account that much more attractive.
Why Invest?
If you are like many of us, we look at our hard-earned money as food on the table, a roof over our heads, and clothing on our backs. We naturally follow Maslow's Hierarchy of Needs. It's clearly a good way of living as opposed to wasting your funds on trivial goods or addictions. However, to preserve your purchasing power over time, it is necessary to invest. Purchasing power, simplified, is how much a dollar will buy you today as opposed to 10, 20, or 30 years ago. Due to inflation, an economic "rule" that states that purchasing power of the dollar loses value by 3% each year, the money socked away under your mattress is losing value as each day passes. So, hiding your money isn't keeping it safe.
Using the example mentioned before: how much is a dollar worth 30 years ago compared to today? In today's money, a dollar in 1990 is worth roughly half (about $.53). So, if you have been sitting on $100,000 since 1990, the purchasing power of that money has fallen to $53,000.
Facing Your Investing Fears
To take the fear of starting investing even further, many of us unconsciously believe in something economists call the "Cockroach Theory." Yes, that actually is an economic term. The technical jargon behind this theory is that when the market falls by hundreds of points consistently, there is disequilibrium in the market; therefore there must be much more bad news to come. The plain-language interpretation of this theory is that we all watch the news, and when the market is down, it leads the broadcast. We tend to remember the bad and not the good. So when we see one bad thing - we believe that there are more bad things, or "cockroaches", to come. When we see one or two cockroaches, we know there are hundreds more where they came from.
Whatever it is, fear of losing your money because it isn't in front of you or that investing is a cockroach kitchen, we are here to help alleviate your fears. There is one and only one rule we want you to learn to believe in when you're learning how to start investing: invest for the long run. As you will see, if you invest your money in low-cost index funds using dollar-cost averaging (DCA) – please don't be intimidated by these terms – we'll make it easy. Just keep reading.
Things to Understand Before You Start Investing
It is incredibly important to understand that proper investing takes a lot of hard work, homework, and effort. We will give you the best tools we can to get you started and want to help you begin (or continue) your journey well-equipped.
As with everything in life, risk v reward is what you'll live and die by as an investor. We highly recommend a risk-averse strategy. You can grind your way into success with minimal risk in securities like low-cost mutual funds and smart investing in blue-chip S&P 500 stocks. Smart investing is the mindset that you are in the market for the long run (5+ years). Most of said securities yield steady yet relatively small returns in the first few years - but be patient. The more comfortable you become with investing, the more creative you can become. Just realize that slow and steady wins the race.
Basic Building Blocks
Understanding some fundamentals of economics (i.e.: supply and demand, equilibrium, the Fed, market trends, GNP/GDP, perceived value, inflation, and the ilk) will undoubtedly give you a leg-up when investing. Explore and read our blog articles and listen to our podcasts to get a deeper understanding of some of these concepts. It's as easy as searching for terms you may not be familiar with from our blog and/or podcast episodes. Brad and Jonathan, co-founders of ChooseFI, are financial and economic gurus that can give you easy-to-understand definitions of complex economic terminology.
It is incredibly important to understand that proper investing takes a lot of hard work, homework, and effort. We will give you the best tools we can to get you started and want to help you begin (or continue) your journey well-equipped.
Risk vs. Reward
As with everything in life, risk v reward is what you’ll live and die by as an investor. We highly recommend a risk-averse strategy. You can grind your way into success with minimal risk in securities like low-cost mutual funds and smart investing in blue-chip S&P 500 stocks. Smart investing is the mindset that you are in the market for the long run (5+ years). Most securities yield steady yet relatively small returns in the first few years. Be patient. The more comfortable you become with investing, the more creative you can become. Just realize that slow and steady wins the race.
Understanding some fundamentals of economics (i.e.: supply and demand, equilibrium, the Fed, market trends, GNP/GDP, perceived value, inflation, and the ilk) will undoubtedly give you a leg-up when investing. Explore and read our blog articles and listen to our podcasts to get a deeper understanding of some of these concepts. It’s as easy as searching for terms you may not be familiar with from our blog and/or podcast episodes. Brad and Jonathan, co-founders of ChooseFI, can give you easy-to-understand definitions of complex economic terminology.
The Psychology of Investing
Throughout this guide, we'll touch on "emotional" and "rational" decisions that can negatively or positively improve your bottom line. The "meta" (or "big picture") of these decisions truly is psychological. The psychological drives the emotional and rational.
We understand that it is difficult to divorce yourself from the value of your dollars in order to put them at risk in the marketplace. We also get that no matter how liquid you may be, there is some risk aversion in all of us. You should have a positive experience in investing and also enjoy this article. So much so, we interviewed our co-founder of ChooseFI and market wizard Brad Barrett; and if you've listened to any of our podcasts, you've heard him (along with Jonathan Mendonsa, our other co-founder of ChooseFI) give sage financial advice to us all.
FI Expert Advice
Now is a good time to hear from Brad, who had this to say about the psychological aspects of investing:
“The psychology of investing is vastly more important than the mathematics of investing - or doing what is "optimized." There are some really smart people who don't think that consistent, fixed dollar amount investing doesn't make sense [the crux of FI investing]. They say you should lump all your money in all at once. And you hear that over and over. But realistically that doesn't work for most people. And it doesn't pass the "sleep well at night test." Including me. It's just too much money - for me and for most other investors. Small incremental investing (DCA) is the psychological safety net that we need.”
*Editors note; don't worry, we cover DCA soon.
We mentioned Brad here early in the guide, and not the specific DCA section, for you to understand early on that even someone with well over a decade of investing experience and a high net worth is still psychologically affected by investing in the market. So he is a great example to follow. And don't worry, we'll help you get there.
Elementary FI Investing
So you are ready to begin your investing path the FI way. Excellent choice! Keep in mind that, although these steps may reflect other "expert" approaches, ChooseFI is all about the long run. So, this will not be a hit-fast, get-out strategy. This is a guide to help you be the best long-term investor we can.
Tackle Bad Debt First
Preface: If you are carrying "bad debt" like large credit card balances with high interest rates, pay these off first before you begin investing. The opportunity (and real) cost of not paying down a credit card with an 18% interest rate v putting your money into the market is a financial blunder. Look at the hard numbers: the average rate of return from the market is 7%. If you are paying a credit card balance with an 18% APR and investing in the market, you are losing 11% (18% - 7%) of your purchasing power. Credit cards also compound Interest, which makes you bleed out faster. Pay off these balances.
Now Let's Begin!
It is critical that you start investing as soon as you can. Time equals money. And money invested over longer periods of time accumulates exponentially if invested correctly. Each month you don't invest, you are missing wealth opportunities.
Listen to the guys dive into investing for beginners and how to set up your financial life in episode 276:
[fusebox_track_player url="https://dts.podtrac.com/redirect.mp3/chtbl.com/track/DD815/adbarker.com/stream/FUtw8akGsdUcxjeJU7HY5o1V/traffic.libsyn.com/secure/choosefi/276_Planning_Your_Financial_Life.mp3" social_email="true" ]The Step-by-Step Plan
Create a bankroll, or start-up capital, used for investing ONLY. This allocation of funds cannot include your regular expenses (e.g. rent, groceries, utilities). Conversely, at first, you do not take money out of this fund to pay for rent, utilities, etc. You have to have the psychological mindset that this money is spent. Only use it to grow your nest egg when you start investing.
Create an emergency fund. THIS STEP MUST COINCIDE WITH BANKROLL CREATION. Because you are setting aside a significant portion of your income for investing, you must also set aside an emergency fund. No one plans for car accidents or job loss. Having this money will keep your financial life healthy. Contribute at least 6 months' worth of income to your emergency fund.
Keep detailed records - use an Excel spreadsheet that can calculate dollar changes for you. If you aren’t keeping receipts you should start. Include all money coming in and all money going out (and where). This will improve your financial health in many ways. Most importantly, it helps you set goals for when you start investing.
Make the time to set your investing goals. You are probably thinking this should be number 1 when you start investing. Well, in order to set your investing goals you need to know your limitations. Those limitations boil down to: how much of your money can you comfortably invest? You obviously have made the decision to start investing and have ideas of how you’d like to attack the market. This step is where you create your battle plan.
Open a brokerage account. Now that you have your bankroll and investment goals, it’s time to open a brokerage account. To trade on the stock market, you need a relationship with a brokerage firm. The best way to establish this relationship is to open a brokerage account online. Think of it as a hub for all your investing needs. There are many firms out there, but we recommend Vanguard, Fidelity, and Charles Schwab.
Determine what type of securities in which you’d like to invest. The market contains different types of options, with advantages and disadvantages. We highly recommend low-cost index funds and mutual funds. You can learn more about the differences between stocks, mutual funds, index funds, and ETFs here.
Low-cost index funds: index funds are securities that are financial assets invested in high-performers in the S&P 500. There are many upsides; including a low entry fee, high performance-to-cost ratios, and very low volatility. The only true downside is that they do not offer returns like higher-risk assets do. But, we are in this for the long run.
Mutual funds: diversification is the key upside to investing in these assets. They have their hands in all sorts of financial silos, so if one market is performing poorly, the others usually pull them up. You can also have much more confidence in your risk tolerance because you can choose how conservative or aggressive you’d like to be when you start to invest.
Things to Remember While On Your Path
Continually strive to educate yourself on advanced concepts of investing. Read books, listen to podcasts, and take advantage of free newsletters and ebooks. Embrace the habits of a lifelong learner here.
Understand risk vs reward. Many people belong to two camps: “the stock market will make me a millionaire” or “the stock market is too intimidating so I won’t even try.” There is a happy medium. If you understand the risk of investing primarily resides in the short-term and therefore won’t get punished in the process: you are well on your way. Proper investing is long-term.
Become very familiar with stock charts. If you decide to invest in stocks, it is critical you know how to read a stock chart, which is a snapshot of the asset and its performance. Focus on the “trend line” – which is the line superimposed on the performance graph that indicates how the stock is trending (up or down). Please note that we do not back the idea of investing in stocks due to their volatility and the clear long-run positive growth options that are much more attractive. Only start thinking about stocks when you have nearly reached FI or have reached FI.
Familiarize yourself with the correlation between the stock market and the health of the overall economy. There are trends and similarities between the market and the economy. This will become second nature to you as you become more seasoned and understand more about market fluctuation, but being aware of the strength of the economy and knowing how this will affect your portfolio will help you immensely.
Stay tuned to ChooseFI. Not a shameless plug. Our goal has always been for everyone to be as financially healthy as possible. Our grassroots movement started because there was no real advocate for people who struggled with their finances without strings attached. We believe in helping everyone achieve their financial goals. The FI community has grown to proportions we couldn’t have imagined when we first started. We are all in this together.
Bear v Bull Markets
OK, admit it (we do): we've all posed with the giant bull statue in New York's Financial District. But, what is a giant bull doing on one of New York's busiest streets? The history behind the statue is rich but for brevity's sake.: The Charging Bull (or just "The Bull") was placed in the district right before the New Year in 1989. A proposed symbol of prosperity and power,
The Bull has been a Neo-American icon ever since. Most importantly, it represents the economic ideal of a "bull market" – a period of time when the stock market is flourishing and "charging" ahead. Conversely, a "bear market" marks a period of time when the stock market is relatively stagnant.
What do these different market periods mean to those seeking FI and who want to start investing?
Bull Markets
A bull market: when there is accelerated growth (regarded as roughly 20%) of the market over at least the short-to-long run (1-5 years). This has a ripple effect, touching all parts of the economy: including upticks in GDP, employment, wages, etc. Since there is always a latency period in tracking the market, as with all aspects of economics, speculation through recognizing patterns is key to capitalizing on investing during bullish times.
Keep in mind that during a bull market, prices rise and cut into your potential gains. Do your homework. Bull markets are wealth-making opportunities but pick your spots to avoid losses. "Attack wisely and accumulate" is the bull mantra.
Bear Markets
As you've guessed, a bear market is virtually the opposite of a bull market. Marked as a steady decrease in market growth (again about 20%), bear markets see prices fall, along with the perceived value of stocks and the economy as a whole. Obviously, bear markets are more challenging to navigate than bull markets as the margin of error has the potential to be much slimmer.
Further, savvy investors want to pull the trigger when prices fall in the hopes that when the market rebounds, they can sell for a tidy profit. There is a delicate balance though – when prices drop, they could fall further. They also could trend back up if demand meets supply. FI investors keep this positioning in mind. "Invest for the long-run and stick with it" is the bear mantra.
Financial Resilience in a Bear Market | Ep 172
The Takeaway
Of course, we all can see these are relatively general approaches. The meat and potatoes of starting investing comes down to your risk threshold and your personal financial goals.
Dive Deeper: Read Forbes' take on bear v bull markets here.
Retirement Account Investing
Those on the path to FI are seeking to retire early and be financially stable. There are many tools available that you should take advantage of to start investing for retirement.
401(k)
Most employers offer a 401(k). A 401(k) is a retirement account that allows you to contribute pre-tax dollars to a financial asset (sponsored by the employer through a brokerage firm), and your employer usually will match your contribution (or at least 50%). A standard tool for those starting investing.
The standard minimum contribution is 1% and can range up to 6% - some employers may go higher, but this is the standard range. Your employer usually matches 50%-100% of your contribution. Again, some employers (like State Credit Unions) will match 200%.
Remember, these are pre-tax dollars, so your tax liability is smaller. Moreover, you are getting free money from the employer contribution match. Finally, a conservative rate-of-return estimate of any 401k is about 3%-6%.
Bottom line: max out your 401(k) contribution!
Solo 401(k)
The Solo 401(k) is only for self-employed individuals who do not have any employees (with the exception of spouses who can also contribute). It's also a great vehicle to start investing. The beauty of opening a Solo 401(k) is its generous contribution limits. Under current IRS rules, you are allowed to contribute up to 100% of your earned income or $19,500 (whichever is less) - PLUS, you count yourself as the employer and employee. Therefore, you can double your contribution. As of 2021, all-in (your allowable contributions and your spouse’s) per year is $58,000.
When in the role of employer, your contributions are tax-deductible, which reduces your tax liability. In the role of employee, your contributions are pretax (similar to a traditional 401(k)). Your brokerage firm determines the investment securities available to you. You are responsible for opening the account and determining how you would like the funds invested. Distributions can start at 59 ½.
457(b)
If you are a government employee or work for select non-profit organizations, this retirement option is undoubtedly for you. Offered by your employer, the 457(b) is similar to the 401(k) with one important distinction: you do not pay a 10% penalty if you retire before age 59 ½. This is an incredibly attractive feature.
All contributions are pre-tax, which lowers your current tax liability (another major plus) and are often matched like a 401(k). You have the option to invest this account in mutual funds or annuities; both are conservative, steady-growth securities.
Finally, you do not pay taxes on these funds until you decide to withdraw.
HSA
The Health Savings Account (HSA) is a tax savings marvel. An HSA allows individuals to contribute up to $3,600 pre-tax (as of 2021) to their accounts.
Why is this account so important? Because it offers a triple-threat advantage to you in beating your tax liability.
Pre-tax contributions. This allows you to contribute pre-tax dollars for health-related expenses. You have more purchasing power in using pre-tax dollars, and your tax liability is lowered for the year.
Contributions earn Interest and are non-taxable. So, you'll earn interest on your HSA, and you will not pay taxes on any interest accrued.
Payments used by your HSA are tax-free. You are not liable for taxes when you spend your HSA funds. This is very atypical, as even the most tax-shielded funds have some taxes attached at some point in their lifespan. Sales tax is also eligible for reimbursement under HSA spending.
Related:
The Triple Tax Benefits Of The HSA
How An HSA Fits With Your FIRE Plans
Traditional IRA
A traditional IRA (individual retirement account) is a personal retirement account. They are also the perfect vehicle for you to start investing!
There is no employer match with a traditional IRA; however, the key selling point is that it is portable. If you change jobs, your traditional IRA can "rollover" to another IRA, keeping your tax-deferred status, and no penalty will be incurred. It is always a good idea to keep your money in an IRA before you retire to avoid penalties and compounded taxes (considering IRA cash-outs are combined with your current income).
Traditional IRAs are also where you'll roll over your 401(k) if you decide to leave your job, especially if you are fully vested (have 100% ownership of your 401(k) value). If you quit and cash out your 401(k), you'll be penalized 10% plus face tax consequences. So, before you leave a job, be sure to open an IRA so you'll have a haven for your 401(k) contributions without penalties.
Roth IRA
As opposed to a traditional IRA, a Roth IRA allows for contributions to grow tax-free, and when you reach the age of 59 ½, the funds are withdrawn tax-free.
The downside to a Roth is that the contributions you make are with post-tax dollars, meaning you have to contribute money that has already been taxed to your account. Financial gifts or any other non-taxable income are excluded.
The upside is obvious. Roth IRAs are quickly becoming the most popular retirement vehicle and meet the ChooseFI gold standard for retirement accounts. To properly retire, you should start investing with a Roth as soon as possible.
Dive Deeper:
Little Known Roth Hacks | Ep 210
How and Why to Set up a Roth IRA Conversion Ladder
Make Your Kid a Millionaire: Roth IRA for Kids
Retirement Account Conclusions and the Next Step
The most effective combination of retirement accounts is a 401(k) along with opening a Roth IRA. Your 401(k) decreases your tax liability and you receive free money from your employer. Your Roth IRA offers you excellent tax avoidance with compounding interest and no tax liability for the gains.
In the next section, we'll talk about the Trinity Study and how using this strategy will help you capitalize on saving for retirement. This is a near guarantee of how to never run out of money once you retire.
Dive Deeper:
Save for Retirement With Low-Cost Index Funds
5 Early Retirement Calculators To Get You On Track For Financial Independence
The Trinity Study: The 4% Rule and the FI Perspective
The Trinity Study and its findings are critical to understanding how much money you'll need to retire. The concepts and key points are highlighted here to help you understand the meat of the study results and not get bogged down in its history or complexities. It should help those who want to start investing take the plunge. So we will touch on more of the impact and not so much the technical aspects of the study to make it more digestible. If you have read up on this watershed scholarly article, you'll appreciate this mercy.
The Trinity Study Snapshot:
The 4% rule, or the "safe withdrawal rate," calculates the amount of money you'll need to have invested to retire.
The study was a deep dive into the market performance from 1926-1995 and included a myriad of factors, including market fluctuation, the CPI (consumer price index), changes in technology, and similar concepts. This massive sample size statistically proves the 4% methodology.
Over this time period, the market realized an average percentage return of 7%. So why can't you withdraw 7% instead of 4%? Because purchasing power decreases over time due to inflation (at an average of 3%). Therefore: 7% return – 3% inflation = 4%.
The Math
Formulas and economic concepts:
Calculation of expenses: multiply your estimated yearly expenses post-retirement by 25 (projected annual expenses x 25). For example: if you need $50,000 per year for expenses after retirement, you’ll need $1,250,000 to retire.
Investment assets contain a personal portfolio consisting of a mix of securities. The study concluded that 50% stocks and 50% bonds is optimal, but any ratio of steady growth securities (index funds, mutual funds) works as well.
Compound interest: since you are reinvesting your net investment yield back into the market, the market will statistically preserve your purchasing power.
Due to the Law of Large Numbers, statistically, you can use the 4% rule and have a confidence success rate of 96%. Why? Because of the incredibly large sample size against the population.
*Law of Large Numbers definition: the larger the observable sample size used in a statistical study, the closer you can guarantee an outcome. This is regardless of variables and random events.
*Confidence rate definition: how certain you can rely upon the results of a statistical study due to its integrity of sample data and methodology.
Related: Beyond 4%: The Argument For Flexible Spending Rules In Retirement
The Takeaway
We went back to Brad for his take on the Trinity Study.
"And if you want to be super-conservative, I'd say a 3.25% withdrawal rate is going to basically guarantee success in almost any scenario except for the zombie apocalypse, which we can't account for anyway. So, for most normal investors, 3.25% is just easier; you'll sleep well tonight. I think just giving the degree of "certainty" (I don't want to use that word), but the certainty of some number out there and it's within this range (3.25% - 4%) I'll work off that. Then I feel pretty darn good there's a high degree of likelihood that I'm going to succeed."
Brad Barrett
In summary, you can be 96% sure that the 4% rule will provide you with the optimal strategy for retirement. If you only withdraw 4% of your net investment each year (and have to stick to the expenses you have allotted) you can nearly guarantee you will never run out of money.
Dollar-Cost Averaging (DCA) & Investing the FI Way
If you have done any research regarding investing before coming here (shame on you), you have heard of dollar-cost averaging (DCA). And, if you are intimidated by this term you aren't alone. It invokes a fear similar to being back in school and studying a subject that doesn't fit in your wheelhouse. Well, we're here to make it digestible and executable, especially for those who are thinking of starting investing.
First, let's break away from investing and back up to general consumerism. We, and by "we," I mean those on the path to FI, always look for the best deal we can. Groceries, electronics, basic needs – we coupon (verb) and shop around for the best price. This is a practical decision, but also an emotional one. We are emotionally connected to money. But, not so connected that reason overcomes emotion.
A Real-Life Example
For example, you are aware that your favorite allergen-free laundry detergent is going on sale in two days for half price; however, if you need laundry done today – you will be "emotional" and purchase detergent today. In economics, this is referred to as comparative indifferences in utility. Forget that term, but keep the rest in mind for DCA.
As we saw in a previous section (bear v bull markets), you know that the market is volatile, even when bullish. You want to make the smart moves; the rational moves. Because being the smartest and the most rational equals being the most successful investor possible, right? Well, not exactly. Even the best investors cannot predict the rise and fall of the market even in the best of bullish conditions. So, with all that considered, how can we do the best we can with this imperfect market information?
DCA Application
Let's marry basic consumerism and investing with DCA and talk about DCA in layman's terms. DCA involves investing a set amount of money into a security at set intervals over a defined amount of time. For instance, say you have $10,000 you want to invest. You worked hard for that money, so you need to put it to work for you.
A savings account? Unfortunately, this isn't 1995. Since 2001, the Fed has notoriously kept the federal funds rate so low that it can't beat inflation. But, you don't want to take on too much risk. You start investing. The decision is to begin with $100 in a security once a month for 100 months (roughly 8 and a half years). You keep some liquidity over time in case you need to break glass, but you keep money invested in the market that will yield compound interest returns on investment.
DCA also works because even great investors tend to buy when prices are priced higher (on lifetime average) and sell when prices are lower (on lifetime average).
*Editors note: "lifetime average" means the lifetime of the market, so roughly 100 years.
Buying high and selling low is emotional, not practical. It's the laundry detergent example used earlier, just in reverse. We want to get out when prices are trending low and get in when prices are trending high. This is an inverse correlation to winning long-run investing.
The Best DCA Strategy
Low-cost index funds with a set amount invested over time. This kills two birds: low-cost index funds are very predictable (v the rest of the market), plus the price for entry is incredibly low, and we also avoid the "emotional" flaw many investors make by setting an interval fixed dollar investment. Mitigating costs plus a solid, steady return equals a great investment strategy.
Using dollar-cost averaging with low-cost index funds should be the crux of your investment strategy. It balances your portfolio and is a long-run winner. And here at ChooseFI, we are always about the long run.
FI Expert Advice
We asked Brad to weigh in again:
"Every time you get a paycheck, you're just putting in a portion of it in the market. If the market is up, then OK, that's fine: you get to buy a fewer number of shares. If the markets down, you get to buy them on sale; you're getting more shares. It all averages out in the long run.
Not for nothing, but the habit formation you create with the continual investment of money on a set interval is psychologically satisfying. For the average investor I think that is the path to success is understanding this is this is a long-term game. There's no short-term. Some believe that we "play the market" instead of investing for the long run. If we can get away from that casino mentality and forget the luck factor, we can get the right strategy. "Lucky" is not a strategy; it's just like catching lightning in a bottle, which can't be replicated."
Brad Barrett
Dive Deeper: Read more about dollar-cost averaging and low-cost index funds here.
Robo-Investing Apps and FI Approaches
We have discussed how the market ebbs and flows. There is some predictability to the trends, but guessing (even educated guesses) includes rational and emotional decisions. We have empirically observed these trends for almost 100 years. Therefore, there are mathematical algorithms that have been created to mitigate risk and magnify reward. The "problem" is until recently, computing power and accessibility have not met the consumer market. Now it has. Introducing the robo-advisor/investor, which is an app that automates much of the decision-making for you and optimizes market choices. With many of these apps, you can simply choose your risk tolerance, investing goals, and assets you'd like to invest in. The robo-investor does the work for you. Let's discuss the pros and cons of robo-investors and some of ChooseFI's favorites.
Pros
Low-cost. With any automated service, costs remain low. This holds true for robo-investors as well.
Access to fund options that may not be available to “non-robo” investors. This primarily includes purchasing partial ETFs (exchange traded fund) which are sought after but have timing and accessibility issues that may confuse those just starting to invest.
Optimized using advanced mathematical algorithms for peak performance. The mathematical models used by robo-investor utilize hundreds of thousands of variables and market results over decades to make the best decision.
Little to no minimum balance is required. Many firms require a minimum balance. Most robo-investors do not.
Cons
No personal interaction with a broker. With robo-investors nearly all transactions and interactions are electronic. So, there is no “personal touch.” This may be intimidating for all levels of investors.
Personalization is an issue. You can typically set your risk tolerance and some other factors and options, but personalization is limited. For power investors, this can be a turn-off.
Complaints include the lack of a human touch regarding finessing your portfolio. Similar to cons 1 & 2, without a human broker involved, there is no mechanism in place to micro-personalize and tweak your portfolio.
Auto-rebalancing can be frustrating for advanced investors. Even though the mathematical models are tried-and-tested, the inability to make changes to the automation process can place-out some investors
M1 Finance
M1 Finance is a robust, multi-featured robo-advisor that’s a favorite amongst the Choose FI community. Built for those just starting investing and advanced investors alike, M1 is a great choice for any path toward FI. The interface is one of the best on the market today, making trades and selling securities easy and straightforward. Here are some of our favorite features of the app:
No fees – yep, zero
An automated M1 Pie feature (we’ll discuss this in a bit more detail below)
Advanced algorithmic rebalancing (‘on the fly” adjustments to your portfolio to maximize investor return)
Fractional shares – this is especially alluring considering the rarity of this option in regards to ETFs
Multiple, diverse securities to choose from
A clean, easy to understand dashboard
Requires little to no maintenance by the investor – depending on how much control you desire
You can check out our full review of M1 Finance here: M1 Finance Review 2023 - The Finance Super App
M1 Finance Pies
A unique feature exclusive to M1 Finance is their M1 Pies feature. When you fire up the app, you’ll be asked to start your portfolio. You will build your portfolio with slices of a “pie.” One slice of your pie could be a stock, security, or fractional shares of an ETF…the possibilities of diversification are incredible. 100 slices of a pie make up your overall portfolio.
To add even more value, M1 has introduced Expert Pies. These pies are created by the financial experts at M1 that have used both quantitative analysis and their own market experience to create killer ETF diversification pies. The following are their requirements for ETF Expert Pie inclusion (simplified):
A performance history of at least 2 years.
A scoring system using Expense Ratio, AUM (Assets Under Management), and annualized Tracking Error.
Each of the ETFs is compared against the two best performing in each of the three categories (listed above in number 2).
The cool thing about Expert Pies is that you can simply “follow” an expert pie and have that make up your portfolio, or you can add an Expert Pie to your own custom pie as a slice. Again, it gives you the flexibility to either just “set-it-and-forget-it” (sorry for all the poker references) or add incredible 3rd party value to your portfolio with no cost to you. We cannot stress enough how powerful of a tool M1 Pies is to investors.
Dig Deeper: M1 Pies: Level Up Your Dividend Strategy and Optimize Your Portfolio Like a Pro
Advanced FI Investing Ideas
As Warren Buffett says: "our favorite holding period is forever." You know you are at this point when you have holdings that are helping or have helped you achieve FI and want to accumulate more wealth. Here are some ideas for the advanced FI investor.
Real Estate
Real estate investing is a difficult proposition after the 2008 crash when 200,000 Americans were left homeless and others completely underwater on their investment property holdings. To invest in real estate, study the areas you'd like to invest in and see how tax assessments and neighborhood comps have trended over the past 10 years. Also, the smart play is to invest to rent, not flip. So do a little research to see how many other rentals, including apartments, are nearby and occupied.
The 1% Rule. This simple formula of mortgage price + costs of maintenance and repairs x 1% will give you a solid idea of a property's positive expected value over the investment time. For example: if you can purchase a property for $250,000, you should charge no less than $2,500 per month for rent. If there are comparable, available rental properties renting out at less than this amount, consider seeking elsewhere. Please keep in mind this is just a risk assessment tool designed to help you ballpark potential return, not a hard-and-fast rule.
Real estate is like the stock market. Since the housing crash, we've been going through a bearish real estate market. Considering the high entry fee for purchasing this type of investment, choose wisely.
Dive Deeper:
How Real Estate Investors Make it Work in High Interest Environments | Coach Carson | Ep 387
Mindset, Financial Independence, and Real Estate | The FI Couple | Ep 430
Real Estate Investing Strategies With Paula Pant | Ep 142
Precious Metals
Gold, silver, and platinum are the "Big 3" of intrinsic value metal investing. Many investors start in the precious metal market because of its proven historical stability and the portability of the asset.
We include it here in the "advanced" section because precious metals, although stable, are expensive to purchase compared to alternative investments. Currently, ten ounces of gold will cost north of $18,000 at "spot" price (or fair market value).
The reason you should add precious metals to your investment portfolio is relatively defensive. You are protecting liquid cash on hand against inflation. While the precious metal market has seen falls and spikes over time, in the long run, they are an excellent diversification asset.
Invest in Companies You Believe In
We don't mean that if you enjoy Coke products, invest in Coke. Don't necessarily invest in companies that make products you enjoy, but organizations you've seen trend upward over time. This only comes from experience. You can read every book on investing, economics, and statistics and still not get the "feel" needed to perform this task. So, if you are FI or well on your way, take some of your funds and put them into long-term playing performers that you've seen grow over time. This is where you can let emotion come into play. Have fun with your portfolio. You've earned it.
What Is NOT Considered Investing?
There are many "investing" domains that are often referred to as investment projects but do not pass the sniff test here at Choose FI. Here are some examples that we'd like to debunk as investing options.
*Note: if you have an interest in these fields and want entertainment and ROI bang for your buck, venture at your own risk!
Bitcoin and Other Virtual Currencies
Bitcoin, the current market leader in cryptocurrency, has gone from a virtual unknown trading tool to a household name in today’s society. In its early days, mining was the trend in obtaining one of the 21 million Bitcoins in existence. Now, with nearly 90% of them in circulation, the trend has changed drastically. PayPal and Square have opened their doors to Bitcoin trading, allowing regular people to trade crypto. Other virtual currencies are available, but they pale in comparison.
The reason we don’t consider this a stable investment tool is because of its volatility. It has the opportunity for dramatic growth, but also dramatic loss. With its supply cap and high price for entry (1 BTC = $55,0000), it’s unknown where investors will end up. Most importantly, there isn’t enough data (as Bitcoin was created in 2009) to determine the long-run growth. And, as you know, that’s the gold standard at ChooseFI: the long run. We want steady, proven results.
Related:
Blockchain, Smart Contracts, and NFT’s | EP 361
Name Your Fear, Control Your Risk | Ep 382
Day-Trading
"It's only when the tide goes out that you learn who's been swimming naked.'"
Warren Buffett
The multi-billionaire's famous quote is in dearest regard to the latency of the market. While long-term investors can pick and choose their spots to make trades, day traders rely on pushing short-term edges for comparative minute returns. We can look at investing vs day trading in terms of cost-benefit analysis (CBA).
Investing costs (v day-trading): give up short-term gains (especially with momentum), the inability to hedge can be frustrating if you see an opportunity, adrenaline junkies don’t get their fix.
Day-trading costs (v investing): standard processes (shorting-stocks, scalping) are typically -EV (negative expected value), pushing margins require patience and taking loss after loss, if you cannot maintain precision and are ready to constantly pull the trigger – retire.
Investing benefits (v day-trading): investing generates wealth; especially in the long run, bull and bear markets are more predictable without constant trades, investing offers many more options at distance with a comparatively low variance.
Day-trading benefits (v investing): savvy daily traders can capitalize on heavy hitters, pushing small edges in the grind can be profitable, riding momentum has a positive utility byproduct.
Professional Opinion
Barbara Roper, director of investor protection at the Consumer Federation of America, has this to say regarding day trading: "People are obviously attracted by the promise of big gains, but they are just as likely, maybe more likely, to suffer big losses."
Further, Neale Godfrey of Forbes says, "If you are an amateur [at day-trading], you may be playing with fire. Your odds of success are like those of any other high-stakes gambler."
We combat this day-trading methodology by reiterating to do your homework and set your sights on the long run. Oh, and invest in low-cost index funds using DCA. Let day traders contribute dollars to the market pool for you to take later.
Collectibles
Whether they be flash-in-the-pan products (Pokemon and Magic the Gathering cards – possible to reprint en masse) or discontinued/OOP (comic books, vinyl records), there are clear diminishing marginal returns on these "investments." A poor launching pad to start investing.
Hot products on the market always have the potential to be reprinted (forget "Limited Edition"). How many early Magic the Gathering players have "guaranteed authentic" Black Lotus cards? Further, these products tend to lose tremendous value when they go out of vogue. Finally, grading is critical in collectibles – which is incredibly subjective.
As with any niche interest, there is an intangible utility in collecting; however, our goal here at ChooseFI is FOR YOU to achieve FI. So, our views on collectibles don't include this value.
The Bottom Line
Jonathan has the following advice for our readers:
"Financial Independence is possible for everyone, but the exact path will look different as we all start from different places with unique obstacles. With that acknowledgment I firmly believe that being on the Path to FI unlocks incredible options in your life and is the most obvious choice to maximizing the time we have on this earth. These are the simple rules of winning at life that you wish someone had taken the time to teach you in school. These principles work every time but only if you take action. So get started and enjoy the freedom that comes with being on the path to FI."
Starting investing is a critical step in your journey to FI. To accumulate wealth, you need to invest in the market—no bones about it.
Our Goal for You
We hope the goal of this article has been achieved. For you to go forewarned and forearmed with the proper knowledge and tools to either start your investing journey or augment your current one.
We can't stress our approach enough: make the market work for you. Be conservative and consistent. Our firm belief is to take the investing strategy of purchasing low-cost index funds using DCA. This approach removes a lot of the guesswork regarding a fluctuating market (bullish or bearish), mitigate loss, and gives you the best bang for your buck.
And, when you begin to reach FI or are FI – you can start experimenting with some risk-tolerant assets to help grow your wealth at an accelerated rate. But keep in mind that understanding the market and doing your homework will keep you from losing your wealth footing. Experience increases as time goes on. Pay attention and keep your eyes and ears open for new opportunities to take advantage of down the line.
