Part 2: Personal Finance 101 — Investing
Note: this article is based on the US system with additional information for international students in the US. This article is also targeted at 20-somethings but applicable to all.
Parts of the series (these are all equally important)
Einstein (maybe?) said “compounding is the eighth wonder of the world.”
If you start with $100, and save $500 every month when you’re 25 until you retire at 65, with a 7% annual interest rate, you’ll have $1.2 million at retirement.
If you start with $100, and save $500 every month when you’re 35 until you retire at 65, with a 7% annual interest rate, you’ll have $556,000 at retirement (less than half after losing out on 10 years of compounding).
In our lifetimes, capital has appreciated (gained value) faster than wages, rich people know this, it’s actually one of the main contributors of inequality (but that a topic for another day, read about it here). The point is that it’s important to invest because it’s important to compound your money, that’s how wealth is actually gained.
Now in combination with investing, you should equally think about paying off debt and having emergency savings (we’ll get to that below).
Pro tip: to make sure you’re not even tempted to spend the money you want to invest, set up auto transfers. For example, my roth 401k and HSA are automatically drawn from each pay check before I even see it. You can also have set amounts auto-transferred from i.e your checking account to an investment account each pay check.
Tax advantaged accounts
What is a tax-advantaged account? Usually when investing, you get taxed on the capital gains (i.e. when a stock goes up in value and you sell it), and tax advantaged accounts help you save on that. Also, you know how you’re taxed on your income? Well, some tax-advantaged accounts help with that as well. We’ll get into that below.
Here is the order in which you should fund accounts:
Pro tip first: A Roth IRA or Roth 401k means you put in after-tax money, but you get to take the value out tax-free. A non-Roth version means you put in pre-tax money and you get taxed when the money is taken out (i.e. you don’t pay income tax now, you pay it later). If you think you’ll be at a higher tax bracket when you retire, use the Roth version if it’s available. If you’re unsure, try an online calculator.
- 401k or Roth 401k up to employer match. If you’re employer matches some portion of your contributions, make sure you get that free money! Sign up for the 401k amount to be taken out of each paycheck so you never even see it.
- Traditional IRA/Roth IRA or max out the rest of your 401k/Roth 401k. Both of these accounts are tax-advantaged, you can read about their similarities and differences here. IRA’s and 401k’s are both accounts used for retirement savings.
- HSA. An HSA is a savings account that you fill with pre-tax dollars, that can be used for certain health-related spending (and it’s pretty broad what counts as health-related). You can only get an HSA if you’re on a high-deductible health plan (which may be particularly nice if you’re young and healthy). As of a couple years ago, you can invest your HSA and you should think of it as another tax-advantaged investing account.
- Other applicable tax-advantaged savings accounts (they end with SA i.e. Flexible Savings Account (FSA), Limited Purpose Savings Account (LPSA), dependent care FSA). These accounts all let you put in pre-tax dollars and take money out for specific uses. Warning: there’s usually a limit on rolled-over amounts each year, past that point it’s use it or lose it.
- Additional brokerage accounts such as a personal investment account through companies like Schwab, Robinhood etc.
Notice from this list that personal investment accounts are a last priority, after all the tax-advantaged accounts have been fully funded. For context, in 2020, the 401k contribution limit is $19 500, IRA limit is $6 000, HSA limit is $3 000, those 3 accounts combined are $28 500 so it takes quite a lot to fully-fund those accounts
$28,500. If you are thinking “wow I could never save that much”, remember, a little bit compounds a long way, so please get started with whatever is feasible.
Note: if you’re self-employed or saving for children, read this article for more tax-advantaged accounts applicable to you.
Note: each country usually has their own system of tax-advantaged accounts. I would just google “tax-advantaged accounts in BLAH” i.e. here’s a list for Canada.
The theme of this article that I hope you take to heart is “aim in the direction of good, not perfection.” When it comes to investing, 20% effort will get you 80% of the way there, so don’t worry about anything fancy unless you’re incredibly comfortable with it.
Pro tip: emotional investors lose money. Don’t freak out when people are shouting about the market being low or high. You’re investing for your long-term goals (i.e. retiring decades from now or buying a house 10 years from now). A good way to stay unemotional is to check your accounts every once in a while (i.e. rebalance once or twice a year).
Types of Investments
- Target funds are super simple, if you want to retire in 2060, you can get a target retirement 2060 fund. You just put money in there (perhaps an automatic withdrawal from your account every month) and then you set it and forget it. They’ll do the allocation and rebalancing for you so you your risk is spread out and rebalanced automatically.
- Roboinvesting (algorithms doing the buying/selling/portfolio management for you) can similarly be a set it and forget it strategy. Some roboinvesting platforms are free (such as Schwab’s) and some cost money, depends on what you’re looking for.
- ETF’s are funds that track an index, sector, asset, etc. An extremely popular ETF is one that tracks the S&P 500 index. A computer will invest in the top 500 companies traded on US stock-exchanges, and invest in them proportional to how much they occupy the top 500.
- To spread out risk in your portfolio (the concept is if one thing goes down i.e. tech stocks, maybe others will go up i.e. real estate), you can buy multiple types of ETF’s. There’s also a lot written about portfolio allocation strategies which I won’t get into here. There are so many to choose from (i.e. S&P 500, track the entire US stock market, US dividend stocks, US gov bonds, Bitcoin/Ethereum prices, Chinese consumer stocks, gold, Canadian offices, Latin America real estate, Chinese company bonds, top European companies, etc.), and you should allocate based on your risk profile.
- Picking individual stocks is really risky. Most of the market is composed of bots written by stats geniuses, and I don’t know about you, but I’m not a bot-writing stats genius. But even I still invest in individual stocks for fun, because I like certain stocks, because I believe in them, etc. but it’s more of a hobby than it is for long-term financial well-being and I try to reflect its riskiness by making it a smaller portion of my long-term plans.
A really good book about personal finance which follows these principles (obviously he came up with them before I did) is I Will Teach You to Be Rich by Ramit Sethi, I highly recommend it!
In part 1 of this series, I write about which bank accounts to open, why a credit score is important and how to get a high one, as well as how to save for huge life events like buying a house. Read part 1 here.
In part 3 of this series, I write about methods to pay down debt, budgeting methods, and how to be thoughtful about giving. Read part 3 here.
Hope this was useful, and remember, don’t let perfection be the enemy of the good, so just get started!
Disclaimer: The information provided, opinions expressed, resources cited, and service providers mentioned in this post are not intended as, and should not be construed as, financial, tax, or legal advice. I am not an attorney, tax preparer, accountant, or financial advisor, and I do not hold myself out to be any of those professionals. The contents of this post are not a substitute for legal, tax, and financial advice from a professional who is aware of the specific facts and circumstances of your individual situation. I expressly recommend you seek advice from a professional on these matters. I do not sponsor, endorse, verify, or warrant the accuracy of the information found at external sites or subsequent links. The opinions expressed in this post are solely my personal opinions and are not connected in any way to any past, present, or future employer.