NOTE: All financial situations are unique, and this article should not be viewed as comprehensive financial investment recommendations. Please consult a financial professional about your specific financial situation and/or conduct complete research before investing.
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We frequently discuss 401(k)s, Roth IRAs, HSAs, and brokerage accounts because these are the mechanisms that facilitate investment in your future, your health, your joyful activities, and your retirement. However, these mechanisms do not grow to their full potential unless the account owner invests their money in a manner that promotes long-term growth.
Most importantly, contributing to any of the accounts above is not enough. You must contribute the money and then invest it in something. Money that is contributed to a 401(k) is not automatically invested. You must choose your investments to make that money grow.
But how should you invest? Investment advice can be overwhelming. There are many multi-million and multi-billion dollar companies with the main objective of advising customers which investments to make. You could subscribe to hundreds of newsletters discussing the best stocks to pick, when to short a stock, when to buy futures, and which ETF (exchange-traded fund) is the best mix of companies involved in the next up-and-coming industry.
Excuse me, what!?
I do not subscribe to any of those newsletters or track what Tesla is doing today, and I would not recommend diving into these rabbit holes for anyone other than an advisor for Berkshire Hathaway who makes six- or seven-figures to know this information. Assuming you are not a financial advisor at a top firm, tracking specific stocks and subscribing to multiple newsletters geared towards day traders is more likely to cause analysis paralysis than comfort in your investments. A simpler approach exists.
Bet on a Bit of Everything
Folks who claim investing is like gambling are either extremely good at blackjack or usually think of investing as picking stocks. Do not pick stocks. Or play blackjack. Instead, bet on the entire market.
When you invest in a stock, you buy a “share,” basically a small unit of that company. You are betting that a particular company will successfully grow and generate more income, increasing the value of that share. For example, if an investor buys a share of Company XYZ stock for $5 and Company XYZ has a great year, the stock’s value may grow to $7. The investor is $2 wealthier and could potentially withdraw $7 even though they invested only $5. Alternatively, if the company has a poor year, the share price may decrease from $5 to $4.
Many companies grow, many fail, and many are positively mediocre. Buying shares of a company stock is risky because if the company’s performance drops, or the company fails, you lose money.
But while one company fails, another one grows. This provides an opportunity for investors.
A prudent investor can invest in an index fund (or a mutual fund that functions like an index fund) rather than a specific company. An index fund is a collection of many stocks, like a mutual fund, that is based on an index of a particular sector of the stock market, or even the stock market as a whole. By purchasing a share of an index fund, the investor is a shareholder of a tiny piece of many companies all at once. If one company fails, it will not cause financial ruin because the investor is also invested in many other companies.
The S&P 500 is a well-known index. As the name suggests, it tracks 500 of the largest companies included in U.S. stock exchanges. If a company included in the S&P 500 does exceptionally poorly, there are 499 other companies to even out investment returns.
For additional peace of mind, the S&P 500 is also considered a self-regulating index because when the total value of the company’s shares held by all stockholders (also called the company’s market capitalization) falls below a certain threshold, the company is no longer eligible for inclusion in the S&P 500 and will be replaced by another company. In other words, if a company’s value decreases, it gets kicked out of the index because it does not meet its basic standards. An index fund tied to the S&P 500 Index will similarly self-regulate and swap out companies as necessary.
Each index has slightly different rules for when a company qualifies for inclusion. So, how do you pick the best index? Here are three rules:
The index fund should include a large and diversified collection of companies. “Large” means a higher number of companies. “Diversified” means stocks from many different industries, not just tech companies or oil companies. Diversified collections prevent the investor from feeling market fluctuations if a certain industry experiences a downturn.
The index fund should be self-regulating (also sometimes called self-cleaning). This means the index fund should have rules that would remove companies that underperform its required standards.
The index fund should have a low expense ratio. The expense ratio is the percentage you pay in maintenance fees for investing in the account. For a self-managed account, an ideal expense ratio is below 0.2%.
Using these three standards, there are two main types of funds to simplify your investing and invest your money today.
Option 1: Target Date Funds
Particularly if you have an employer-sponsored retirement plan like a 401(k), the target date fund is a popular option. A target date fund is not exactly an “index” because it includes many different types of investments, but you can think of it as an index that tracks the ideal allocation for someone who wants to retire in a particular year. The composition of a target date fund changes as you approach your target date. Target date funds include a mix of investments that are riskier, with the opportunity for large growth, when you are farther away from your target date. The investments become more conservative as the target date approaches. For example, a target date fund with a target date of 2025 would include the lowest risk assets and experience only conservative growth. A target date fund with a target date of 2065 would contain optimistic investments with a huge growth potential but the possibility of decline. A target date fund of 2045 would provide a balanced portfolio in the middle of these two, including some risky investments and some safer ones.
If you intend to follow a traditional career path, working 35-45 years and retiring at age 59.5 or later, choosing a target date fund with your intended retirement date is a terrific choice to simplify your investments. You can choose that fund when you are 25, never change investments, and it will automatically rebalance your portfolio to decrease risk without you ever thinking about your retirement funds.
You can also choose a target date fund that is different from your intended retirement date to match your risk tolerance. For example, my current 401(k) is invested in a 2050 target date fund, but I plan to retire from my day job more than two decades earlier. Since my ideal plan is to retire in my 30s, I have the freedom to accept a lot of risk: If my portfolio experiences a downturn immediately before my actual intended retirement date, I can just work an extra year or two in my 30s until it begins growing again.
On the other hand, if you are fifteen years from your prospective retirement date but are extremely risk-averse, you can choose a target date fund that is five years away. There are no rules forcing you to invest according to your planned retirement date. Use your retirement plans as a starting point, and adjust for your risk tolerance. Additionally, you can always decide to start investing in a different target date fund if your risk tolerance or plans shift.
Target date funds typically have low expense ratios, but expense ratios included in employer-sponsored 401(k) target date fund options can often depend on your employer. My 401(k) offerings have slightly higher expense ratios than I would typically accept, but my generous 401(k) match more than compensates for enduring them. Expense ratios may be higher than 0.2%, but you can usually still find expense ratios below 1% in your 401(k). If your expense ratio is higher than 1% and your employer match is not generous (it should be!), you may want to consider how much to invest in your 401(k) as well as if it is worth rolling over to an IRA more frequently.
Option 2: Total Market Funds
If you ever walked down the beach and saw a person in their 40s wearing a “VTSAX & Chill” shirt without a care in the world, you observed the low-stress existence resulting from investing in a total market fund. Total market funds include small pieces of many publicly traded companies, so you can bet on the market as a whole rather than specific companies. Companies may fail, but if the entire market does, there are bigger issues than your retirement account.
VTSAX is a popular total market fund recommended by JL Collins in The Simple Path to Wealth because it is Vanguard’s Total Stock Market Index Fund and has a low expense ratio of 0.04%. Vanguard paved the way for self-managed accounts with low expense ratios, but other companies have followed suit. Fidelity, for example, now has similarly successful total market funds with low expense ratios.
Total market funds are the best choice for accounts like your IRA or brokerage account. Any account that is not an employer-sponsored account is a great candidate for total market funds with low expense ratios because you have complete control over the funds you choose. If you are lucky enough to have access to total market funds with low expense ratios through your employer, they are also great for 401(k)s or HSAs, but that is rare.
For folks with financial advisors, any expense ratio under 1% is considered good. However, when you add up the hundreds of thousands of dollars you lose over your career by paying a 1% fee annually, you may reconsider whether it is worth the cost. You can find plenty of self-managed funds with an expense ratio below 0.2%. Whether you have a Vanguard account with access to VTSAX, a Fidelity account with access to FSKAX, or another account, investigate the total market funds provided. Find one with an expense ratio below 0.2% that is self-regulating. Click invest, enjoy the compound interest, and total market index and chill.
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