Hey hey! And welcome back to lesson 7 of The Minimal Investor!
Whew, 6 lessons to get to the point where you’ve made an investment and tracked it. That may sound like a long lead up time, but think how much of your life you didn’t know how to do that.
I made my first investment in a 401k at my first job – but that wasn’t my first informed investment. For that choice, I looked at what funds returned the most in the past 12 months and just picked one of them (ack!). It took years to learn about fees, diversification, tax-efficient fund placement, and taxes (which is next week’s lesson and one that many people have said is the most useful of all!).
Lesson 7: Pay Yourself First Mindset
Now that you have an account setup and know-how to pick funds for it, let’s spend some time going over how to invest going forward. There are a lot of ways we can trick ourselves into thinking we’ve outsmarted the market. Today’s focus is on how to disprove those myths and put a plan in place to grow your investments in a consistent way with minimal risk.
Here’s a brief outline of what we’ll cover in this slightly-shorter lesson:
- Pay yourself first mindset
- The magic of dollar-cost averaging
- Tune out the noise, turn off the news
By the end of this lesson, you should have an understanding of what the future of investing looks like for you going forward.
1. Pay Yourself First Mindset
If you have a 401k or are familiar with how they work, this will be an easy comparison. With 401ks, you set part of each paycheck to invest automatically. Once this is set, you don’t need to think about it. You just continue to save that much from each paycheck and live off the rest.
This is the idea behind a pay yourself first mindset. Doing this can be scary at first. You may have a fear of scarcity by lowering your take-home pay. What’s great about this method is that you can increase or decrease the amount – giving you flexibility.
Here’s what worked best for me: tracking every single dollar I spent for 3 months. This probably isn’t going to be fun, but it helps develop a relationship with your money that is hard to put into words – and a different connection that you get by using tools like Mint and Personal Capital.
I do this via a Google Spreadsheet. I group expenses by category that have come up as most important to me over time. Whenever I spend money, I find the month and the category and update the cell to read =15, meaning it was a $15 purchase. The next time I make a purchase, I just update this cell to read =15+5 when I’ve made a $5 purchase. It’s not important for me to know exactly what the purchase was or when it was, but the category is the most important part. If I want to dive deeper later, I can track down my credit card transactions and find the corresponding transaction.
How you want to track this spending to understand it is up to you, but it’s important to know.
Armed with this information, it’s possible to start cutting out things spending or areas you aren’t receiving value from. I don’t use this to set artificial budgets for myself. Instead, I use it to get a high-level view of my spending to know what’s out of whack and could be corrected.
In the first few months doing this, you might also find some things you’re spending money on you’re not even using – which is basically free money if you cancel.
The Time Cost of Money
Vicki Robbins, author of “Your Money or Your Life” (one of the pivotal books about financial independence) stresses the importance of understanding the time-cost of your purchases. Here’s how it works:
First, calculate out your yearly take home pay after taxes. This would include your 401(k) and any other income you’ve earned during the year. If you’re in a household with multiple earners and you combine funds, you can add everyone’s income together. Let’s say that your entire household income after-taxes is $60,000.
The next step is slightly more difficult: calculate how many hours of work it took to earn this money. For this, you’ll want to include every minute that went into earning it. The time spent at work, time commuting to and from work, time spent answering emails from home, time spent buying new clothes just for work, time spent doing your makeup for work – and any other work-only time. Let’s say this comes out to 50 hours a week, times 48 weeks; or 2,400 hours.
When I first did this exercise I realized that even though I was only working 8 hours a day, my time-cost of money was closer to 10 hours. And that was with a 20-minute commute!
The last step is to divide these two: $60,000 / 2,400 hours = $25/hour. When I did this calculation for the first time, it was a real “a-ha!” moment for me. Even though my hourly pay was $55 at the time (which is already great), the actual time-value of my money was about half that.
Remember this number the next time you’re making a purchase. Is that $50 dinner hour really worth 2 hours of your time? Or could you make dinner instead? Sometimes the answer will be yes!
Adam says: It’s possible to go overboard on this. Be honest with yourself and understand when you feel something is worth the cost and when it’s not.
Budgets vs Savings
The goal of all this tracking isn’t to set a hard budget to stick to. Instead, the hope is that you know exactly how much you should save immediately when you get your paycheck – and just save it. After that, your 401k, Roth, Brokerage account, or savings account where you’re saving your funds will start to grow. It’ll seem small at first, but in 1 year or 5 years or 10 years, you’ll be thankful for past-you taking making this choice.
One key to having this work is for your checking account to have a few months buffer in it – I use 6 months. My checking account always has enough money in it that I could live off it for 6 months. Because of that, if I save at the beginning of the month, then spend slightly more during it, I’m not dipping that account into the negative.
In fact, my checking account will occasionally decline because I’ve saved too much! To correct things I’ll turn off savings for a month and use a paycheck just to refill my checking account back up to that 6-month buffer.
When I think about saving, I like to imagine myself a year from now. What does future me think about how much I’ve saved? Does he wish he saved more? Is future me happy that he started saving a year prior? I want future me to always be thinking “damn, past me did an awesome job.” Paying yourself first is a great way to set yourself up for that.
Takeaways:
- Try tracking your spending to know how much you actually spend. (and use as an opportunity to prune obvious expenses you don’t use)
- Save up an emergency fund. This should be somewhere between 3 and 6 months of your monthly spending.
- Set up an automatic deposit that happens immediately after you get paid. (or raise your 401k contribution higher!)
As for which account to put your money in (401k, Roth, brokerage), check out this handy chart again to see which makes the most sense:
2) The Magic of Dollar-Cost Averaging
Putting money into the market for the first time can be scary. When you choose your investments, you have no control over what happens next. For me, it takes an understanding of how the stock market works to feel comfortable putting money in.
Historically, that has absolutely been the case. The same way we know the markets have historically risen, we know that there will be times when the market goes down. What you do during those times can make or break your investment performance over the long-haul.
This is going to be easier to say than to do but here goes: “If the market drops, even by half, and you’re in a well-diversified portfolio: don’t sell anything.“. Instead, think about it as if the market is now on sale. You’re still able to buy just as much of the companies as before, but now at a lower price.
As I’m writing this now, it’s August 2020. Back in March when COVID-19 hit, the S&P 500 dropped 34% in less than a month. Imagine you had spent decades saving money – paycheck by paycheck – and made it $1,000,000. In just one short month your money dropped to $660,000. You “lost” $340,000 that took you years to make.
But you didn’t really lose it. The price has just dropped. You only “lose” this amount if you sell. Markets as a whole have always recovered from these drops. 2020 has been one of the most unique (crazy?) examples of that. If you hadn’t sold at the bottom (at $660,000), your investment would have recovered back up to $960,000 as of July 31st.
Markets fluctuate. If you’re in a diversified, low-cost portfolio then you have time on your side! You can wait for your investments to recover.
Actually, if you were in a diversified portfolio of 70% S&P 500 / 30% Bonds ($BND), your $1,000,000 portfolio would have only dropped to $757,579 and recovered to $987,276. In a downturn you’ll be thankful for bonds!
Individual stocks aren’t so lucky. Just look at Bear Sterns or other companies that went out of business in 2008. If you were holding specific stocks during a drop, there is no guarantee they’ll ever recover. This is why index funds are so great: we don’t have to worry about that at all! Instead, we can rest assured that the index fund we’re in will be invested in some funds that go up and others that go down, allowing us to be somewhere in the middle.
Side note: there may be tax reasons to sell after a drop then rebuy into the market due to taxes. This is a strategy called “tax-loss harvesting” that we’ll talk about later in lesson 8 on Taxes.
What does this have to do with dollar-cost averaging?
Oh right! You knew this had to be going somewhere, right? The concept of dollar-cost averaging (DCA) is putting money into the market over time, regardless of the cost at that time, rather than all at once. If you’re earning a paycheck and putting money into the market each month, you’re already dollar-cost averaging.
If you get your paycheck and look at the stock market only to think “Oh wow the S&P just broke it’s all-time high today, I’m going to wait a few days then invest” then you’re not dollar-cost averaging – you’re gambling. This mindset – that you’ll know when the market has reached its peak, and again when it’s fallen to a new relative low, requires you to be correct twice.
The only three truths about the market:
- A well-diversified portfolio will insulate you from the worst swings.
- Over time, the market as a whole has always gone up. (that’s not to say it always will, but it always has)
- You know just as little as everyone else when a peak/fall will happen.
J.L. Collins also has a 4th truth:
The market will do whatever it can to embarrass the most people.
Rather than trying to time the market on each investment, I recommend setting up an automatic deposit and not even thinking about it. If you second guess yourself by wondering if you should invest today then you’re letting your fear of a future event cloud your judgment.
The market goes up much more often than it goes down. If you’re reluctant to invest because the market has gone up a bunch recently – don’t be. That’s normal!
Imagine you’re playing roulette. Roulette has 37 numbers – 18 black, 18 red and one green (00). Betting on red or black is essentially a coin flip.
Betting on if the stock market will go up or down isn’t. In any given year there’s about a 75% chance it’ll go up. If you increase that to 5 years it’s closer to a 95%. Increase that to 10 years and it’s closer to 98%. Increase it to 20 years and it’s 100%.
Again imagine you’re playing roulette. The roulette wheel has 37 numbers – 35 black, 1 red, and 1 green. How much would you bet on black? That’s what it’s like to invest over a 10-year period.
If you’re investing for retirement over a longer period then there are essentially 37 black numbers. There’s still a chance an earthquake hits and the ball jumps out, but historically it’s as good an investment as you make.
It’s time in the market, not time of the market.
This quote highlights an important fact – 20 years from now it’s much more likely that the biggest difference in your account balance will be how long you’ve been in the market, rather than when you tried to start. You want your money in the market for as long as possible, and the best way to do that is to invest it ASAP.
What if I invest a bunch now, then the market drops?
This is a really common question. Remember that over a long enough time the market has always gone up. That means that more than likely the value in a year, 5 years, 10 years will be higher than it is today.
If you’re waiting for the market to come down before putting funds in then there is a chance that will never happen. By trying to optimize results for the worst case (ex: you invest and the market crashes tomorrow), you’ll miss out on the much more likely path – that the market goes up tomorrow.
If the average of the market was to go down, then it would absolutely make sense to wait. That’s called a deflationary economy – think Germany in the 1930s. Unless you’re in Venezuela or Zimbabwe you don’t need to worry about that situation today.
Over the last few years, I’ve seen a lot of people sitting on the sidelines – not wanting to invest until the next drop in prices. I strongly encourage you to not be one of these people. I say that full well knowing that it’s possible stocks could drop tomorrow. More than likely though, that won’t be the case.
Should I invest a lump sum with DCA?
If you do find yourself with a bunch of money, it can be scary to think about investing it all at once. Going back to the fact that the market tends to go up over time – statistically, your best bet IS to invest it all at once immediately.
When my mom passed away she left me about $100k. I was scared about what to do with it. I went to a financial advisor and despite all other disagreements with them – this was one thing they did right: they invested it all at once.
Let’s think about this for a second. What if you did have $100k to invest today and you decided to dollar-cost average it into the market by investing $10k/month for the next 10 months? How would that change things?
Unfortunately, there’s no way to know without a crystal ball. Again, what we do know is that on average the market goes up. Because of this, on average, we would miss out on some of the gains by dollar-cost averaging it over time.
If you do have a lump sum and you want to DCA, the worst thing that would happen is you miss out on some gains from your investments. The best case is the market drops, and you buy it for cheaper. I’d go with whichever way helps you sleep at night and get money into the market the fastest.
If you can’t get your head around investing it all at once, then by all means DCA instead. Getting your money into the market sooner than later will have the largest impact on growth down the line.
Takeaways:
- Investing money over time, regardless of price is called “dollar-cost averaging”.
- Don’t try to time the market.
- It’s time in the market, not time of the market.
3) Tune Out the Noise
The worst thing you can possibly do is watch cable stock shows. Ok, so maybe not the worst, but it’s up there.
These shows and almost every article about stock markets are written to get lots of eyes on them. They have no stake in your investments – only you do. Don’t let them scare you into selling, or to feel like you need to make an asset allocation change. If you are in a well-diversified portfolio, then you have absolutely nothing to be scared of.
This took me a while to understand. Regardless of the news, if you’re in a diversified portfolio you don’t need to keep up with the news.
There will be times when your investments go down. You may look for what you could invest in instead that’s going up. I strongly recommend you DON’T do that. Sticking with a diversified strategy is the best possible way to build wealth in the stock market long term, and it’s exactly what those who are the absolutely richest would recommend; Warren Buffet for one.
If you let yourself be scared by an article (and it is a choice to be scared), then you are letting yourself be influenced by someone whose job it is to influence you.
Instead, let yourself be influenced by the greatest investors in the world – those who have built great wealth through simple means.
Tim Ferriss shared a great story on his podcast where he had a chance to ask Warren Buffet a question:
If you were 30 years old and had no dependents but a full-time job that precluded full-time investing, how would you invest your first million dollars, assuming that you can cover 18 months of expenses with other savings? Thank you in advance for being as specific as possible with asset classes and allocation percentage.
Tim Ferriss
Buffett let out a small laugh and began.
I’d put it all in a low-cost index fund that tracks the S&P 500 and get back to work…
Warren Buffett
If this course is about being a minimal investor, Warren Buffett is as minimal as they come! He didn’t talk about taxes or asset allocation like we did. He just went all-in on one fund. He also didn’t say anything about timing the market or which accounts to use. The point Buffett is trying to make is that investing doesn’t have to be difficult.
You can spend hundreds hours each trying to beat the S&P 500, but there’s no guarantee you will – regardless of how much news you watch. Even the experts can’t consistently beat the S&P 500. It’s extremely unlikely that you’ll be an exception.
You may get lucky and outperform the S&P 500 some years. It’s much harder to do it every year for 10, 30 or 60 years. One bad year could even ruin decades of “good” performance.
This is the goal of being a minimal investor in my eyes. I don’t want to worry about my investments. Instead, I want to be able to create and spend time with people I love rather than spend it watching cable shows on what stocks I should buy buy buy.
Takeaways:
- Diversify your investments then tune out and live your life
Lesson 7 In Review
It’s great to get started investing, but keeping up that momentum is what’s going to get you across the finish line. If you understand how much you spend and set up automatic investments, you can largely forget about this. You’ll be dollar-cost-averaging your investments automatically after each paycheck and be in great shape.
Be like Warren Buffett – invest then don’t worry about it.
Next Lesson
We’ll get into taxes, and what you can do pay the least amount. We’ve touched on some reasons for using one account type over another for specific funds (bonds in tax-deferred for example), but next, let’s look at what happens when we actually want to sell funds sometime down the line.