Category: Finance

This is a continuation of a series of posts on personal finance. You can read the entire series here: https://blog.shinadachi.com/category/finance/

If your employer does not offer a 401-k or 403-b, there is still a way to get a similar tax advantage while saving for your retirement with an IRA (Individual Retirement Account).

IRAs are recommended over normal investment accounts for a simple reason: the significant tax advantage that it gives you.

IRAs come in two flavors: The traditional IRA and the Roth-IRA. They are taxed differently, as follows.

Traditional IRA
A traditional IRA account can be funded with your pre-tax money. This means that whatever you invest into an IRA account this year can be deducted from your income, resulting in a smaller income tax for you.

Once invested, your money will grow tax free, unlike a normal investment that incurs a tax on your capital gains.

When you take the money out in retirement, you will pay income taxes on whatever you take out.

Roth-IRA
A Roth-IRA account is funded with your post-tax income. This means that you will NOT be able to deduct your investment from your income. But because you have paid taxes before the initial investment, you can take it out in retirement completely tax free. And just like the traditional IRA above, the money also grows tax-free.

Which should you choose?
If you are trying to decide between a traditional IRA vs a Roth-IRA, consider how much your income is now, and how much you expect you will draw from your IRA in your retirement years.

This is not easy to figure out since your life and your future has a lot of unknowns, but the typical advice is that for young low-income earners, Roth-IRA may be the optimal choice as your income is likely lower today than in the future. You have a long time to amass a significant net-worth, which will likely lead to withdrawals in the future larger than your current income. I purposefully did not draw the line the separates young/old or low/high income, as each life situation is different and there is no clear answer here.

My case is a little special, because as an engineer and a freelance musician, I tend to make a lot of money in certain years and not in other years. So I actually invest in a traditional 401-k (similar rules to traditional IRA) in the years I work a normal day job, and convert a portion of it to a Roth-IRA when I focus on music. The conversion is considered a taxable event, but since I make significantly less money as a musician than as an engineer, my income for the years I work as a musician is taxed at a lower percentage.

How do you start an IRA account?
Most investment services allow you to open an IRA account with which to invest your money. Whatever you choose, a good philosophy to follow is to do the following with your assets.
1. Invest most of your assets in a diverse stock index fund. I like Warren Buffet’s advice, 90% stocks, 10% bonds, and rebalance occasionally to keep the ratio. This is good because even though the stock market is volatile, it has a higher average annual return in the long-run than other investment vehicles. One precaution here: volatility of the market makes some investors scared, or react to the market (like selling all of their stocks after a market crash). Don’t be like those investors, and stay invested and consistently stick to the 90/10 ratio for the best long-term results.
2. Invest with a firm that does not charge you a high fee. When I got my first job and started investing back in high school, I made the mistake of investing in mutual funds with fees as high as 1% annually. In hindsight this didn’t make much sense when many index funds have expense ratios below 0.1%.

Vanguard is considered the king of index funds with their variety of offerings and low fees. I am quite fond of their VTSAX fund, which is the total stock market fund that exposes you to the entire U.S. stock market. How cool that you can be a part owner of every single publicly traded U.S. company by simply investing in this one fund! There is also the VBTLX, the total bond market index fund. So implementing Buffet’s advice of 90% stocks and 10% bonds is easy with Vanguard. Invest 90% in VTSAX, 10% in VBTLX, and rebalance occasionally as the market fluctuates to stay close to a 90/10 holding ratio.

I also love the wealth of low-fee “robo-advisors” available today that implement strategies similar to the above, but does all the work of investing/rebalancing for you. This includes services like Schwab Intelligent Portfolio, Wealthfront, and Betterment. Robo-advisors tend to have much prettier and easy-to-use user-interfaces compared to Vanguard, so they are recommended for people who may not be interested in learning the nitty-gritty details of the different kinds of funds but simply want an easy way to consistently put away money for their future without having to think about it.

Many people tell me that when it comes to investing aggressively, fear often gets in the way. But when I talk to them, I quickly find out that their fear is based on their emotions, and just by having more information, they can get over their fears and start investing wisely. Too often, our fears are unwarranted and we don’t even know it.

For example, here are some comments I’ve heard from my friends just in the recent months:

“Other than my real estate properties, I hold a lot of my assets in cash. I just can’t go into the stock market, I’m scared that it is way too overpriced.”

“I just sold all of my stocks recently. I’m glad I did it because the stock market hasn’t gone up at all this year.”

“It took 25 years after the Great Depression for the market to recover. I can’t risk an event like that happening again. I can’t afford to wait 25 years to get my money back.” (This is not true by the way, it doesn’t take 25 years to recover, as I’ll argue in this post.)

All of these fears are understandable. Just the potential of losing money is scary, and I actually used to have the same fear before I studied about this topic more and have come to the understanding that my fear was purely based on the lack of my knowledge.

Having said that, there are a few things that you must understand when investing for the long-term.

You will lose money in some years.
The stock market does not always go up. So if you’re invested in the stock market, you will lose money in some years. I lost close to 40% of my assets in 2008. And guess what? That’s totally okay! You’re actually in good company when you lose money, because even Warren Buffett, the world’s best investor, loses money in those years too. Which leads me to my next point:

You will gain money in most years.
And these years are quite profitable. Way more than enough to make up for the lost years in my first point.

You cannot predict which year will be which.
This is really important. You cannot predict the market. That doesn’t mean the market is completely random. There actually are ways to evaluate whether the market maybe over or under-priced, and one good way is to calculate the price-to-earning (P/E) ratio of a broad stock market index and compare it to the historical average. But even with that information, you still can’t predict what the market will do that year. Take 2017 as an example. It seemed that the market was overpriced at the start of the year. Seeing that the market is overpriced, an investor could have sold all his stocks predicting that it will go down (sadly, some people actually did). Well guess what? By the end of the year, the market gained a whopping 21.7%!

It’s costly to be NOT invested in the market.
It is tempting to sell your stocks when the market seems overpriced. But when you sell your stocks, you miss out on the potential growth, and history has shown that the market tends to have just a few days every year when the most significant growth occurs (we’re talking multiple percentage points in a single day). The only problem is, nobody can predict when those days will come. So how costly is it when you miss out on the few good days? Consider this fun thought-experiment:

Suppose you had $100,000 on January 1st of 1994, and decided to invest all that money for two decades, ending on December 31st of 2013. That’s a total of 5037 trading days. If you kept all of the asset in an S&P 500 index fund for all of those trading days, you will have a hefty $583,520 sitting in your account at the end of the experiment. Cool! You survived the dot-com crash of 2001 and the housing-crash and financial melt down of 2008 just fine, and you can now retire comfortably on your money. Readers in Los Angeles or New York might disagree and argue that they need a few million dollars to retire, but remember, the reason why people seek to live in these expensive cities in the first place is because of the wealth of economic opportunities close to a center of commerce. But if you are financially free, the prospect of a well-paying job doesn’t factor into your decision anymore. You can pretty much live anywhere in the world at that point.

Now, to continue with the thought experiment, consider this alternative: Suppose that instead of investing your money for the entirety of the 20-year duration, you took your money in and out of the market due to fear, and you happen to miss out on forty of the best trading days during the 5037 trading days span (that’s less than just 1% of the duration). Guess how much you’d have at the end. A mere $81,490. Remember, you started with $100k. You actually LOST money over those twenty years, simply by missing out on those forty days of trading. It turns out that fear could be very costly.

When it comes to making a financial decision, you are much better off going with what the research says, not what your emotion tells you to do. And the research says that the people who stay invested see much better returns than people who try to time the market. So stay invested at all times.

Count your wealth by how much of the economy you own, not dollars.
Money is just a piece of paper. Although it is a pretty useful piece of paper for trading goods, there is no inherent value in it. But so many people think that there is. I even know of an extreme case of a family who holds most of their assets in cash hidden in various places of their house. They do things like that because they think that money is valuable. It is not. When you hold onto cash, you are actually constantly losing wealth over time, because the purchasing power of a dollar diminishes over time. Economists call this “inflation”. Just think about it. A person could buy a hamburger for 12 cents in 1950. Well, that’s not true anymore, in fact you can’t buy much of anything for 12 cents nowadays. So by keeping 12 cents under your bed thinking that you could treat yourself to a nice juicy burger in some future date, you lost all your purchasing power. That’s essentially what happens when you just keep cash. Money loses value over time.

But it is so tempting to compare prices simply in terms of dollars. I’ve met some old people who talk about the “good old days” when everything used to cost cents. Well they forgot one important factor: their wages were much lower then too, and their purchasing power was actually lower in those “good old days”. Most of them couldn’t afford a color TV, for example.

It’s also the same misunderstanding that causes people to think that they got a raise when their salary goes up, because they simply look at their wealth in terms of dollars. If your salary goes up by 1% every year, you are not getting a raise. In fact, your income went down, because inflation raises the consumer price index by more than 1% per year.

When you think that your wealth is measured in dollars, it makes sense that you would have an aversion to loss by investing in the stock market. After all, your $100 today could suddenly drop to $60 tomorrow, and it appears that you “lost” your wealth. But that’s not how I think of it. I count my wealth in terms of the proportion of the world’s economy that I own, because essentially, that’s what I am buying when I invest in index funds. Suddenly, the ups and downs of the market don’t affect my emotions anymore, because even if the market crashes tomorrow, I still hold the exact same percentage of the economy. So my wealth hasn’t really decreased, first, because prices of goods also drop with the market keeping my purchasing power relatively stable, and second, now those shares are at a steep discount! If the market crashes and loses half its value, I can afford to buy double the shares for the same amount of dollars all of a sudden! So the market crash is not bad at all. In fact, it’s a great opportunity for me to keep investing.

When you invest consistently, you naturally end up buying more shares when they are discounted due to downturns, and that leads to a significant wealth over time. Market downturns are actually to your advantage.

It won’t take 25 years to recover from a crash.
This is partially related to my last point. If you simply look at it in terms of dollars, it does appear that the recovery from Great Depression took 25 years. But you know by now that your wealth is not to be counted in dollars. Remember, this was a deflationary period when the prices also went down, so if you just look at purchasing power alone, it turns out that the recovery only took 4.5 years, not 25. Plus, this person was assuming that he invested ALL of his assets right before the market crashed, and didn’t invest a single dollar after it crashed. But that’s not what you’d be doing if you’ve been reading my posts. You will likely start investing way before the market crashes and see significant growth in your funds that makes the loss of a crash not hurt as much. And even if you do get unlucky and invest a significant amount of money right before a crash, as long as you keep investing after the crash, you will still be in golden shape.

So there you have it. Hopefully now you have a better understanding of the market, and are not that afraid to invest. There’s no telling when the next crash is. It might happen tomorrow. It might happen in 20 years. It doesn’t matter. Just keep investing.

New to this blog? Check out all of my finance series here.

Whether you invest in index funds, other mutual funds, or individual stocks, you can get a tremendous tax advantage by investing your money through a bucket that the government calls “401(k)”. If you work in the public sector, a similar alternative available to you may be called “403(b)”, but the name is not as important as the concept. (For curious readers, the names directly come from the U.S. statutory tax law code that created this retirement plan option and defined its terms).

401(k) is a retirement account that you fund directly from your paycheck. To get started, simply set it up with your employer. The difference between a regular investment account and a 401(k) account is in how the money is taxed, as explained below:

1. You can fund a 401(k) with your pre-tax money.
   This is significant. Suppose that you earn $100 through your job, and you decide to invest it. With a 401(k), you can invest all $100. With a regular investment account, you have to pay taxes on it first (let’s say $20), so you’ll only have $80 left to invest. This initial difference, when invested with compound interest over time, makes a huge difference.
2. Dividends and Capital Gains in your 401(k) account are not taxed.
   In a regular investment account, dividend payouts from your stocks are taxed as ordinary income. Also, any gains in its market price of your stocks from the time you bought them to the time you sold them, are taxed in a form of tax called “capital gains tax”. However, 401(k) accounts on the other hand, will not tax you on dividends and market gains, so your money will grow tax-free.
3. Contributions you make to a 401(k) are often matched by your employer.
   If you are lucky enough to work for an employer who matches all or a portion of your 401(k) contributions, you have to take advantage of it. This is basically free money, and it’s not often that somebody will pay you free money, but this is one of those scenarios! Everybody should contribute to a 401(k) account to get the most match they can get from their employer before considering other investment options.

If all of this sound too good to be true, well, it’s all true. So far, you haven’t paid any taxes on anything! The government will eventually want to tax you on your money, so they will when you take the money out of your 401(k) account in retirement. At that time, the money you take out will be taxed as ordinary income. This is fine for most people, but if you expect to be in a higher tax-bracket in retirement, you also have the option, through a similar but different “Roth 401(k)”, to pay income taxes now, and take out the money tax-free in retirement.

New to this blog? You can read all of my Finance series here.

Last time, we learned about what index funds are, and why they are much better alternatives to the typical mutual fund which charges a much higher fee to pay for the “professionals” who manage them. I put “professionals” in quotes because it turns out that they are no better at picking winning stocks than an average person. Remember, picking stocks or trying to time the market is a loser’s game. Your psychology will fail you. Don’t play that game!

Let’s start looking at some of those index funds so you can start putting your money in them.

I will use Vanguard’s index funds for all of my examples. Although you can find similar index funds from different companies, Vanguard was the first company to advocate for and implement the index fund idea, and they have pretty much every index fund you may ever want to invest in, all at amazingly low fees!

Specifically, we will focus today on “target-date retirement funds.” As you can guess from the name, these funds are for people who want to save for retirement, and have a specific retirement date in mind. Putting your money into a target-date fund is the easiest way to save for your retirement, because the fund will do all the work for you: staying aggressive by investing 90% of your net worth in stocks initially to take advantage of time and compound interest, rebalancing the stocks/bonds ratio of your holdings as the market fluctuates, and slowly selling away your stocks in exchange for more bonds as you approach your retirement date to make the fluctuations of the values of your investments less volatile.

You will find all of Vanguard’s target-date retirement funds here. Just click on the appropriate retirement date based on your situation, and if you’re feeling curious to see more information, click through the tabs to see the fees (often called “expense ratios”), and holdings (information on what the fund consists of: stocks-to-bonds ratio, and how much of it is invested domestically vs internationally).

While target-date retirement funds make investing for your retirement super easy, do realize that this convenience comes with a fee (still a very low 0.15%, compared to actively-managed mutual funds that can charge ten times that, how criminal!). Keep in mind that you could get even lower fees if you are willing to invest in even simpler index funds that do not do all this fancy re-balancing and re-allocating for you.

So basically, my advice boils down to this:
If you are a completely hands-off investor who just wants to keep funneling money into a retirement fund, then just go ahead and pick one of these target-date retirement funds. But if you want to take it up one notch, and are willing to do a bit more work by choosing specific funds and the ratio to hold them, as well as doing the occasional re-balancing by trading your stocks for bonds or vice-versa, you can get even lower rates by choosing the funds and managing the holdings yourself.

And final note for today since we talked a lot about retirement: you can get huge tax-advantages by doing all of your retirement investing in these special buckets that the government calls “401k” and “IRA”. Unlike regular investment accounts that charge income tax on dividends and capital-gains tax on assets that go up in value by the time you sell them, you can grow your money tax free in retirement accounts in both 401k’s and IRA’s. The government gives you this tax break because they want to encourage you to save for retirement.

Up next: What is a 401(k)?

New to this blog?
Also check out my previous posts:
Stop trying to time the market.
Why Invest?

As I’ve mentioned previously, index funds that track the stock market are the recommended investment options, and a majority of your net worth should be invested in them. Let’s take a deeper look into index funds today.

What is an index fund, and why is it better than buying individual stocks or mutual funds?

An index fund is a type of mutual fund, but unlike most mutual funds that are actively managed and charge high fees to pay the salary of the people who manage them, an index fund automatically tracks the performance of an index, such as the S&P 500.

Index funds are recommended over actively-managed mutual funds because of their significantly lower fees. This makes a huge difference, because whatever you don’t pay in fees is re-invested in the market, and with the magic (or math) of compound interest, even a 1% difference in fees could mean hundreds of thousands of dollars over the long-term for an average investor. Mutual funds managed by professionals will not beat the market consistently enough to make them worthwhile. They are extremely profitable for the people who manage them, which is why they are marketed like crazy and unfortunately are still popular to uneducated investors today, but the evidence is overwhelming: investors who invest in low-cost index funds see much better results over time. So stay away from actively-managed mutual funds unless they are your only options, that is, if you are investing through your employer’s 401k or 403b plan and you have a limited choice of funds. In that case, still invest in whatever option you do have to maximize whatever employer match you can get, because that is basically free money which you should definitely take advantage of, and whenever you decide to leave that job, immediately roll them over to an IRA invested in index funds to let that money grow more efficiently.

As for individual stocks, buying them is fun but also not recommended for the sake of your future. If the professionals who manage mutual funds can’t even beat the market, what makes you think you can? However, trading stocks is far better than gambling away your money at the casino or through lotteries. At least the expected return is positive with stocks, unless you are trading so frequently to pay more in trading fees than the gain you should make through the market on average. So if you have an itch for gambling, by all means, be my guest and have fun trading stocks. Lotteries are stupid, because the more you play, the more you lose. If you do trade stocks for fun, just remember to only trade stocks with a small portion of your assets, and favor buying and holding for the long-term over trading frequently.

My grandmother actually trades stocks as a hobby, and I support her completely because this hobby is intellectually stimulating for her, and I think it is great for maintaining her sharp mental state even in her old age. I am also quite impressed to see her do it all without a computer. She watches a market-news program that shows the fluctuations of various domestic and foreign company stocks, keeps a mental state of the stocks she holds and their movements over time, and trades her shares through the phone by calling her broker. BUT!! As much as I love my grandmother and enthusiastically support this habit of hers, that is NOT my recommendation for you. My grandmother has invested wisely over her lifetime, has built up a fortune, and now she deserves to have this kind of fun even though her strategy may not be optimal. You, however, in order to optimize your investment, should avoid trading individual stocks, and simply invest in index funds instead. The problem with trading stocks is that because you are basically trying to time the market for each stock you buy or sell, you are often holding a portion of your assets in cash between the time you sell your shares and the time you decide on which company to invest in next. This gets pretty costly over time, because you are missing out on the growth of the market while your money is not invested in the market, not to even mention the fees charged for each trade you make. The overarching trend of the market is that it goes up over time. Even in the last two decades in which we’ve seen the dot-com crash of 2001 and the financial meltdown of 2008, the stock market has still gone up over time, on average. Trying to time the market is a loser’s game for that reason. You miss out on the growth that happens while you are not in the market. A far better alternative is to always be investing by keeping your assets in an index fund at all times.

Up next, we’ll take a look at the index fund that gives you the easiest, hands-off investment option: “target-date retirement fund.”

This post is part of an ongoing series. If you haven’t already, also check out my last post: Stop trying to time the market.

Before we get into the specifics of how to invest to optimize the chance of building the largest fund for your future self, let’s talk about why it is so important for everyone to invest.

Do you love your job?

If the answer is “no”, then absolutely, you should invest. It’s the most sure way of building yourself the financial freedom to turn “work” from something you do to pay the bills and are stuck with for the rest of your life, into something that you do because you want to, when you want to.

If the answer is “yes”, first, pat yourself on the back. You must have worked diligently to get to do the work of your dreams. Well, my suggestion to you is, still, you should invest!

With the rapid rate of change in technology, the nature of work is quickly shifting. In my industry, I often feel overwhelmed by all of the new technologies I must continue to learn to keep pace, and as much as I love my job right now, there is no guarantee that the opportunities for me to continue to do the jobs that I love will always be there. Sometime in the near future, I may want to take a few years off to study. Or maybe I might decide to step away from engineering and become a doctor, a barista, a concert pianist, a carpenter, or take your pick! Maybe I’ll retire early and start a farm in a remote village. Or maybe I’ll be married, and my future wife and I decide to be stay-at-home parents. Whatever my desires happen to be, the only reason I will have these options in life is because I was taught about the importance of investing very early on. When I was a kid, my dad set up a meeting for me to meet and talk to his financial advisor (one of the greatest gifts, thank you dad). Ever since, I have been investing a portion of every one of my paychecks, even if I was working a minimum wage job (in 2004 California, that meant $6.75/hour, or $54/day, which felt like a lot of money for me back then). It was also around the time that my dad left his corporate job to pursue his goal of becoming a pastor. It was the perfect living example, to the eyes of my high-school self, that making wise financial decisions throughout your life can set you up with the freedom to pursue your passions. Again, thank you dad for the awesome life-lesson. Anyway the good news for you is, you actually don’t need a financial advisor. Investing is super easy, and I will show you how.

But first, why should you invest? It is because of the single greatest thing money buys you, which is freedom. Money allows you to live the way you want to live. It frees you from having to please your boss or to keep jobs that you hate. It frees you from the worries of losing your job one day. It allows you to give freely to charities whose causes align with your core values, or even better, quit your current job and go work with those organizations to make a difference in the world with your own hands. It allows you to work when you want to, and spend the rest of the time with your loved ones. It lets you travel the world, and should you fall in love with a place, it gives you the ability to stay there indefinitely instead of flying back. As you build your investments and slowly remove the burdens that come from your day-to-day finances, you gain the power to focus more of your life and energy on what truly matters to you.

Investing is not just for the rich. Everybody should invest. It does not matter what you do or how much money you make. Each time you get that paycheck, you have to make investing a priority before you go out for the celebratory dinner or buy yourself a nice gift.

I’m not saying you shouldn’t spend. But if you do decide to spend your money, do it with thought, and ensure that every spending decision you make is an intentional one, with a clear purpose. Just consider that throughout its history, the S&P 500 index has yielded investors an average of 11.95% annual return. With the dividend and capital gains re-invested earning compound interest, that means a $10 you invested forty years ago will be worth $914 today. Once you come to the understanding that the $10 you spend today is depriving your future self of $914 and you are ok with that, then go ahead, spend away that $10. If not, think twice before every purchase you make. That $3 latte to keep yourself awake? That’s actually a $274 cup of latte. Maybe you should just go to bed earlier so you don’t need coffee to wake you up. The nice $60 sushi dinner? That’s actually costing you $5484. Maybe you should just cook up something at home instead. The $500 weekend trip to a resort? That’s $45701, you can easily live two years off that! Maybe you can skip the trip this time and go out for an inexpensive fun night in your own neighborhood instead.

Next: What is an index fund?

The questions that I get asked often are:
1. “What should I invest my money in?”
2. “I feel like the current market is overpriced. When should I start investing?”

Well, I’ve got some answers for you.

This is a post that I’ve been working on for some time now, but I’ve decided to  publish it since it seems like the appropriate day to do so for what the market did today. I’m sure you got a handful of investment advice from your coworkers who are trying to time the market. (Ignore them, and do your own research).

Now, if you’re like me and have read dozens of books on economics and finance, you probably know already that paying attention to the daily fluctuations of the market is just noise and should never alter the way you invest, and you likely already have an aggressive investment portfolio optimized for the long-term. If you’re that person, you can stop reading now and go do whatever you love to do on Monday nights.

Still reading? Ok, I’ll give you the answers first because I’m in a bit of a time crunch now, and will delve into the topic further in future posts.

“What should I invest in?”
Most of your assets should be invested in an index fund that tracks the performance of the U.S. stock market.

“When should I start investing?”
Don’t try to time the market. The best time to start investing is whenever you have the money to invest. This means that you are debt-free, or have at least paid off your high-interest loans (with annual interest rates over 5%), and have enough cash to handle life’s emergencies, such as a broken car, an unexpected medical diagnosis, or a job loss. Keep investing no matter what the market does. When the market takes a big hit like it did today, invest. When the market is quickly rising like it did all of last year, invest. If it completely tanks like it did in 2008, invest. Get it? It’s simple: whenever you have the money to invest (which should be every single time you get paid), invest.

Next: Why Invest?