Investing Basics

Today, I will go over the very broad topic of investing. I personally follow some of these methods, and I’m not following some of them, and I will let you know of my preference as well, in addition to methods that you should use with a grain of salt, and methods to stay away without a doubt. In addition to my subjective ideas, there are also rule-of-thumbs to follow at all times. So, most of the basic rules I will share below are timeless, you might have read most or all of them somewhere else, they may not be new to an experienced investor, but still, this will be a collection of investing basics. I can already feel at this point that this is going to be a very long post.

From a personal finance standpoint, the simple equation of earnings (not necessarily income) minus expenses will be equal to the amount of money you can save / invest. You can work on increasing income (e.g. side business), or decreasing expenses. The focus of this post will be on making use of the difference between earnings and expenses. However, it is still worth emphasizing that, the primary rule for being able to invest using this difference, is to reduce expenses, and hence save.

Preliminary

Before going over investing basics, here are a couple of things you should know:

1. Investing is a long-term game. Although I will also share short-term investing methods later in this post, long-term investing is the only method that will give you an edge over inflation.
2. Know stock market basics. Learn about stocks / bonds.
3. Asset allocation is usually the most important factor in your investment portfolio. Carefully choose your asset allocation, update it as you age, and stick to the rule, regardless of market volatility.
4. Time in the market beats timing in the market. Timing the market, and getting in and out of the market, requires two correct guesses: knowing when to get in, and knowing when to get out. This is impossible. Market oscillates for various reasons, and by the time these events happen, the changes are priced into the market already, and it is too late to get in or out of the market. Instead, invest your money in the market and enjoy the ride, no matter how bumpy it is.

What You are Working Against

There are also a couple of items that you will need to work against.

1. Yourself. Human nature follows the opposite rules of common sense investing. For example, as one of your investments grow unexpectedly well, you will make the mistake of waiting for the investment to grow further because of the greed, or buy more of the same investment. When your investment grows, your brain will extrapolate the growth and assume that future will be the same as the past. And when in downturn, human nature will tell your brain to panic and sell. However, one of the very simple investing rules is to buy low, and sell high, which is opposite of what human nature says. You need to stick to investing rules, instead of human nature. It is impossible to time the market, and you are no exception. Beat human nature and follow investing basics.
2. Financial advisors. Any financial expert claiming to be an expert on beating the market has a dirty history of making terrible investment decisions for their clients. Avoid. With minimal knowledge on investing basics, even the ones in this post, you will be good to handle your investments yourselves.
3. Taxes. There are ways to avoid them, defer them, and there are ways to invest in the market accurately in taxable vs. tax-advantaged accounts to minimize taxes. Learn ways to avoid taxes. Leverage tax-advantaged accounts. We will mention some methods to avoid taxes below.
4. Inflation. If your money is not racing against anything else, it is racing against inflation for sure. Average inflation rate in the US is between 2.5%-3%. Any investment you make that returns below this rate (after taxes), is causing you to lose buying power, although you are not losing money.

Investing Basics

Below, I will take a stab at prioritized rules for investing. First, we will start with a prerequisite:

0. Emergency fund: This is the rule number zero. Before starting investing, you need to keep 3-6 months of your expenses in an emergency fund. This emergency fund will be for rainy days, be it for an urgent big-item purchase, or funds for expenses in case you are laid off, or for medical expenses for an unexpected health issue. Some people place their emergency funds in their Roth IRAs or online savings banks, which may make sense, but in most cases, it will take 1-2 days to withdraw the money from these accounts, which may be too late for an emergency. Have some of your emergency fund within reach, just in case.

1. Pay down debt: After having an emergency fund on the side, and before doing anything else below for investing, you need to pay down debt. Any debt with a high interest rate will make you sail against the current before you pay it down, because unless you have savings for long-term investment, you will not be able to even beat the inflation rate. For those with high-interest-rate mortgages, car loans, and especially those crazy-high interest student loans: pay down debt before you read any further.

2. Invest in work-plan based pre-tax retirement accounts: The number one way to avoid taxes is to invest in pre-tax retirement accounts, such as 401(k). Your contribute to 401(k) plan without being taxed, and in most cases, your company adds a match on top of it. It’s a legal way to escape from taxes, so invest in your 401(k), and max it out (19K in 2019). Some resources recommend contributing only up to the company match, but the math suggests maxing it out if you can. Note that, your pre-tax money in 401(k) plan grows tax-free, and you can withdraw it without penalty after the age of 59.5. After this age, when you withdraw money from 401(k) account, you will be taxed based on your tax bracket that year. After age 70.5, you are required by the IRS to start withdrawing certain amount of money from your 401(k) plan (Required Minimum Distribution, RMD).

Here is some math behind why you should invest in pre-tax retirement accounts, and even max them out. Mad Fientist article presents a great comparison of money growing in taxable accounts vs. pre-tax retirement accounts vs. after-tax retirement accounts. Variants of pre-tax retirement accounts with different methods of withdrawing money early, have been the clear winner. Here is some more math from FireToBiz. Say you are given $100, and say that your effective tax rate is 25%. There are two cases, you invest in pre-tax account or taxable account:

• If you invest your money in 401(k), say with company match of 50%, you will save $150 for your retirement that day. 30 years later, your money will grow at an average of 7%-10% on average (if you follow the investing advice in this post and invest in low-cost index funds). Assuming 9% annual return on average when you are retired, you will end up with $150 * (1.09)^30 = $1990. When you are retired and want to withdraw this money, you will be taxed at your effective tax rate for that year, say 15%, which will result in $1990 * 0.85 = $1691.
• If you invest your money in taxable account, you will be taxed immediately, going down from $100 to $68 (assuming this earned income falls into 32% tax bracket). Letting it grow at 9% per year for 30 years, it will become $68 * (1.09)^30 = $902. Assuming 15% long-term capital gains tax, the money you will end up with is: $902 * 0.85 = $766 (Even if you have zero earned income and end up in 0% long-term capital gains tax rate, you will end up with $902.). This is less than half of what you end up with in pre-tax retirement account.

The math is quite clear. Pre-tax retirement is, without any doubt, the method to prioritize in investing. It gives you leverage over taxes by delaying the taxation, and in most cases it gives you extra free money through company match. Make sure to use this legal way to avoid taxes, and make use of free money from your company.

Here are nuts and bolts on how to invest in pre-tax accounts (or any tax-advantaged accounts). Start investing in low-cost diversified index funds. You will read this multiple times throughout this post, but each account type will require a different fund due to the difference in taxation of these account types. Follow 3-fund portfolio, consisting of the following 3 diversified index funds:

• US total stock market fund
• International stock market fund
• Total bond fund

In addition to these index funds, you can have a tilt towards small-cap value (SCV) funds, which is proven to have higher returns than large-cap / medium-cap growth funds. Paul Merriman’s First Time Investor  shares very interesting and convincing statistics on small-cap value fund performance. Recently, in October 2018, he also collaborated with Chris Pedersen and released his newest investment suggestion, where he moved away from his complicated Ultimate Buy&Hold portfolio suggestion to Two Funds for Life , where the first fund is a Target date fund (which is an auto-rebalanced version of 3-fund portfolios with higher expense ratio, and therefore creating your own 3-fund portfolio is a better choice), and the second fund is a small-cap value fund.

In order to be more concrete, here is what I invest in my pre-tax account. First of all, my current employer has 401(k) plan in Fidelity (I would prefer Vanguard, and I had employers in the past who had their 401(k) plan with Vanguard, but for now, I don’t have a choice but to use Fidelity). Each employer will have a different choice of funds in their 401(k) plan. For me, I created 3-fund portfolio using the index funds available in 401(k), and used BrokerageLink account inside my 401(k) plan, to invest in a small-cap value fund (because the small-cap value fund in my 401(k) plan had a high expense ratio). Here are my fund choices (which had to be within Fidelity):

• FXAIX: Fidelity500 index fund (proxy for US total stock market fund )
• VTSNX: Vanguard Total International stock market fund
• VBTIX: Vanguard Total Market Bond index fund
• VSIAX: Vanguard Small-cap Value index fund

Asset allocation of your portfolio can change based on your risk tolerance, your age, and other factors. Keep in mind that pre-tax retirement accounts have money which you will ideally not touch until the age of 59.5, so it is ok to take risks here if you are even 5-10 years out. (I’m 25 years out, for now.). Note that the bond fund choice here is VBTIX, and not a tax-exempt muni bond fund, because dividends paid throughout the time your money grows in 401(k) is not taxed until retirement or early withdrawal. This choice will be different in a taxable account, which I will cover later in this post. Before I close here, I also want to emphasize my current 401(k) plan provider is Fidelity, and it can change as employers change (my preference is of course Vanguard, but likely, I can find Vanguard funds in Fidelity with no fees as well.).

3. Invest in after-tax retirement accounts: In this type of retirement accounts, you contribute to your retirement account, Roth IRA, with after-tax money, and you withdraw it tax-free after the age of 59.5. Roth IRA has income limitations, but a backdoor Roth IRA lets you convert your traditional IRA to a Roth IRA, even if your income is too high to open Roth IRA. The maximum contribution to Roth IRA for 2019 if $6K. Note that you can split your Traditional IRA and Roth IRA contributions to sum up to this $6K contribution. The question of whether to contribute to Traditional IRA vs. Roth IRA is a commonly asked question, and it depends on your current marginal tax rate vs. your expected marginal tax rate at retirement. I highly recommend reading more about the differences between Traditional IRA vs. Roth IRA, before contributing to one (or both).

There is another method to contribute to Roth IRA, which only some companies allow in their retirement plans, and that is the Mega Backdoor Roth IRA. With Mega Backdoor Roth IRA, you can first contribute after-tax money to your retirement account, and then automatically convert to Roth 401(k), which will grow tax-free from there onwards. The overall defined contribution limit for 2019 is $56K, and in addition to pre-tax contributions plus 401(k) employer match, the rest of $56K can be filled with Mega Backdoor Roth IRA contributions.

Here are my specific index fund contributions for Roth IRA and Mega Backdoor Roth IRA. I have my Roth IRA account in Vanguard, so I currently invest in the following:

• VTSAX: Vanguard US total stock market fund
• VTIAX: Vanguard International stock market fund
• VSIAX: Vanguard Small-cap value index fund

That’s right, no bonds, at least at my current age (34 while I’m still there). Roth IRA grows tax-free, and it should have your most risky asset allocation. It should also be the last money you touch during retirement, even after spending from pre-tax contributions in 401(k) (because 401(k) will start RMD after age 70.5, and you want to spend from your pre-tax 401(k) between ages of 59.5 and 70.5, to ensure your tax bracket is reduced when RMDs are withdrawn from your 401(k) account after the age of 70.5.). Note also that, REIT stock funds are also a good choice of investment in tax-advantaged accounts (both pre-tax and after-tax), because their dividends are unqualified dividends, and hence taxed at ordinary income tax rate. Therefore, it also makes sense to include REIT stock funds (e.g. VGSLX) in these tax-advantaged accounts. I haven’t invested in these funds yet, particularly because REIT stocks are already included in VTSAX and VTIAX. But if you want a tilt towards REIT stocks (which pay high dividends), tax-advantaged accounts are a good place. (And once again, use REIT stocks only, and only, in tax-advantaged accounts, and not in taxable accounts).

My Mega Backdoor Roth IRA contributions are in my Fidelity retirement plan with my employer. And I use the exact same portfolio in my pre-tax 401(k) account, which I mentioned above: FXAIX, VTSNX, VBTIX, VSIAX.

4. Invest in taxable accounts: And of course, for the money that you want to use before retirement age of 60 (which is the society-accepted retirement age, which need not be your age at retirement), which you may want to use in your earlier phases of your life, you can (and should) invest in taxable accounts. First things first, only invest in the stock market in taxable accounts if you will not use the money in the next 3-5 years (this duration changes based on resources, some say 1-2 years, but being safe and using 3-5 years as the limit does not hurt. And if you check past recessions in stock market history, you will find some recessions that recovered in close to 2 years (2008 and 1929)).

Let’s cut to the chase. I recommend you follow 3-fund portfolio again (and I add a small-cap value fund tilt based on Paul Merriman’s suggestion), just like in tax-advantaged accounts, with one caveat: You need to be careful about bonds. Bond and bond fund dividends are unqualified dividends, and they will be taxed at ordinary income tax rate. This rate is around 45.3% (35% federal tax + 10.3% state tax) for me right now, which is a big no-no. You need to avoid this. In my first try to device a portfolio in my taxable account, I used VBTLX total bond fund, which ended up in tax consequences, until I talked to a Vanguard personal advisor, who suggested me to use tax-exempt muni-bonds instead. Tax-exempt muni-bonds are federal-tax-exempt. The decision to choose between tax-exempt muni bond funds vs. total bond funds depends on your tax bracket, and you need to do some math based on your case. For example, one of the tax-exempt muni bond funds I use in my taxable account is VWITX: Vanguard intermediate-term tax-exempt muni bond. Its current SEC yield is 2.37% based on this page . On the other hand, the SEC yield for VBTLX (Vanguard Total Market Bond index fund) is 3.18% based on this page . After some math, given that I’m in 35% federal tax bracket, the effective SEC yield for tax-exempt muni bond, VWITX, becomes 2.37% / 0.65 = 3.64%, which is higher than the SEC yield of VBTLX, 3.18%. This is exactly why you should use tax-exempt muni bond funds if you are in a high tax bracket. To cut it short, here are my investments in my taxable account:

• VTSAX: Vanguard US total stock market fund
• VTIAX: Vanguard International stock market fund
• VTEAX: Vanguard Tax-exempt Bond Index Fund
• VSIAX: Vanguard Small-cap value index fund

Note that, although there are three bond funds in my taxable account, they constitute only 4% of my taxable account. The rest is like 47% VTSAX, 21% VTIAX, and 28% VSIAX. So, this is still a 3-fund portfolio with small-cap value fund tilt. The asset allocation, of course, as always, depends on your risk tolerance, your age, and your financial goals.

Before we close here, I also want to mention state tax-exempt muni bond funds (e.g. VCAIX), which you can replace with the (national) tax-exempt bond funds above. State tax-exempt muni bond funds are exempt from both state taxes and federal taxes, which is a huge advantage. And if you live in the corresponding state, you might want to leverage these bond funds. The only disadvantage of these state tax-exempt muni bond funds is that states can declare bankruptcy, after which these funds can disappear. Unlikely, but not impossible (see Detroit in Michigan). I’m still considering moving to state tax-exempt muni bond funds which will replace one of the three bond funds in my list above. (One good suggestion I got from Bogleheads forum is to use a mix of national short-term tax-exempt muni bond fund, and state (CA) tax-exempt long-term muni bond fund, which will have an average of intermediate-term duration, while having higher SEC yield come from state (CA) tax-exempt long-term muni bond fund.).

Besides these investment choices, you can also invest in accounts such as Health Savings Account (HSA), if your employer has an HSA plan, and use it towards your pre-tax contribution as well.

Short-term Investment Options

For your money you need in less than 2-3 years, you probably have better use a short-term investment, instead of investing in the stock market. There are several choices. But, before we start with anything else, if you leave your money (other than 3-6 months of emergency funds) in the bank, these days you will get somewhere between 0.01%-0.05% interest (which will be taxed at your ordinary income tax rate). This is below the average inflation rate of 2.5%-3% in the US. Do not do this. At least use one of the following short term investments.

1. Online Savings Accounts: If you are not familiar with investing in stock market or real estate investing, then, place your money in an online savings account at least. The ones I have used and can recommend are Ally Bank (currently 2.2%) and Synchrony Bank (currently 2.2%). You can follow most up-to-date rates in Bankrate website. Note that the interest will be taxed at ordinary income tax rate.
2. CDs: CDs are fixed-term investments, usually with higher returns than online savings accounts, but your money gets locked during the term of the CD, or else you pay penalty for early withdrawal. Interest gets taxed at ordinary income tax rate. There are better options than CDs, see below.
3. Money Market Funds: Vanguard Prime Money Market Fund (VMMXX) and Vanguard Federal Money Market Fund (VMFXX) yield 2.5% and 2.33% these days. They are mutual funds that invest in cash or cash-equivalent securities, such as CDs and Treasuries. You still get taxed at ordinary income tax rate on the interest.
4. Treasuries: Treasuries have a huge advantage over the previously mentioned short-term investments: They are state and local tax exempt. This is a commonly overlooked security, but it is worth checking. Currently, even 3/6-month treasury bills yield around 2.5%. I highly recommend making use of treasuries and creating treasury bond ladder (I use a Treasury bill ladder).
5. I-Savings Bonds: This is another overlooked security type. I-Savings bond yields are updated every six months based on the inflation rate, and it is a great way to have an hedge against inflation rate. Here are the rules: I-Savings bonds are state tax-exempt. They are subject to federal taxes, but this tax can be deferred as long as you prefer, and until you cash it out, you won’t pay taxes on it (Hint: This is a way for tax-free growth in taxable accounts.). You can only sell I-Savings bonds after the first year, and if you sell before the 5th year, you pay the penalty of 3 month’s interest. The current yearly contribution limit for I-Savings bonds is $11K. I haven’t used I-Savings bonds yet, but I thought about it many times. They are great for catching up with inflation rate, and tax-deferred growth outside tax-advantaged accounts.

Maybes and No-nos

You will of course want to try other investment methods or platforms, and this is ok for learning experience. And there are some methods and platforms that you may want to stay away. I will briefly mention some of them here:

• Robo-advisors: Platforms such as Wealthfront and Betterment determine an asset allocation for you based on your risk tolerance after a survey. From then onwards, you don’t change your investments until you change your risk factor. Robo-advisors do the rebalancing of funds based on market volatility. Robo-advisors are good for a starter, but, having read up to this point in this post, you are not a starter anymore, you know what to invest in, and you should prefer to have full control on your funds and asset allocation. Another big disadvantage of robo-advisors among many others, is that, there is a lot of selling and buying going on by the robo-advisor during rebalancing, which makes robo-advisors almost an active investment method. As good investors, you can try these robo-advisors only as a trial, but later you should just ignore them and prefer passive investing by yourself, using the fund suggestions above. (Confession: I tried Wealthfront for a couple of months in 2016-2017, and then I pulled out all of my money after learning more about investing).
• Robinhood: This is a very famous easy-to-use app, where you can buy stocks and ETFs commission-free with one swipe, which is bad for investing, but good for learning experience for beginners on how stock market works. I have done this, and I still have some money in it, watching what is going to happen next, and I’m slowly exiting Robinhood. As long as you have a small amount of money in Robinhood, your investment there will be a good test for you. The very first time you invest in Robinhood, when an investment loses money, you will want to sell immediately, because it just takes a couple of steps in the app. And as you observe what is going on in the market, seeing how volatile it is, you will learn to buy and hold, be patient, and even learn not to invest in individual stocks. At first, I had a high amount of money in Robinhood, and I think I lost $2K in 2016 after panic-selling stocks. In 2017 and 2018, I bought some stocks, but also sold some that had gains, because I wanted to be out of the app. Finally, since 2018, I haven’t been buying in Robinhood, and right now I’m slowly exiting as my stocks / ETFs reach their 1-year anniversary with positive returns. I should be fully out of Robinhood in 2019. As it goes without saying, you should avoid individual stocks. In addition, there is no way to select which lot to sell in a stock / ETF in Robinhood, and Robinhood uses LIFO (Last In, First Out) scheme when selling, which means that they sell the most recently purchased security when you trigger a sell event. This is a no-no, not even a maybe, a big no-no. You have to be able to control which lots of your securities to sell, in order to make sure you can distinguish securities with short-term vs. long-term capital gains. Another no-no for Robinhood is the fact that they don’t have a way to add beneficiaries for your account. Of course you can always have a lawyer for estate planning and add your Robinhood account in the paper work, but most investing platforms have an option to add beneficiaries, although Robinhood does not. In short, I recommend trying Robinhood for a learning experience on stock market investing with small amount of money, but nothing more than that. Later on, stay away.
• M1 Finance: I actually used M1 Finance, and it has been great with its auto-rebalancing along with the option to select out own stocks / ETFs in a portfolio, and allowing fractional ETF shares. I still keep some of my money in M1 Finance, but I stopped contributing for the following reason. The rebalancing frequency of 3-fund portfolio does effect the portfolio performance. Usually, market changes in a day or a week are considered noise. The changes in 6 months or a year are considered substantial changes. The common suggestion for 3-fund portfolio is to rebalance it every year, or every 6 months, and not more frequently than that. In M1 Finance, however, I have a weekly automatic investment, and every time I add cash, it is used to rebalance the account based on the stock market changes during the week. Basically, M1 Finance is rebalancing the account based on the noise in the market. Although M1 Finance takes away the pain of rebalancing every year coupled with some serious math with pen and paper, avoiding frequent rebalancing of the account is the best choice for your returns. M1 Finance is still a great tool though, great job by the owners.

And of course, this needs to be mentioned:

• Individual stocks / RSUs / ESPPs: What would you do with your individual stock investments? AMZN is going up like crazy, MSFT flying these days, NVDA was like a rocket, oh look it is at half of its value now… Exactly. The sole reason to invest in index funds instead of individual stocks and RSUs is because you will have high single-stock exposure, which will lead to single point of failure. Do not do this. Instead, own the market itself, buy the index funds. Although that AMZN stock skyrocketed 50% last year, sell and diversify. How good am I at this? Good to some degree, but not perfect. My PersonalCapital account is telling me these days that I have high single-stock exposure which means that it is time to sell some and diversify. Specifically for RSUs, these are usually your company stocks, and you should not depend on the performance of your company, which is also paying you. When in market down-turn, if your company lays off people, and you turn out to be one of these people, you lose two things: 1) Your salary, 2) Your RSU valuation. Do not rely on a single stock, but more importantly, do not depend on your company stock. For ESPPs specifically, it is best to sell immediately and lock the guaranteed returns in. For example, my company has a 10% discount on their stock value in ESPP program, which gives me automatic (100/90) – 1 = 11.1% increase in stock value. You should just sell immediately and diversify, instead of waiting the value oscillate during stock market volatility.

Besides these investment methods, you can of course invest in businesses, in real estate, and possibly other instruments as well. But for the sake of this post, we focused mostly on stock market investing.

I knew this post was going to be long. And it is not even over yet. But this should be a great start to investing basics. If you follow the advice above that I collected and synthesized from many resources, you should be good to start your investing journey. I hope this helps, and as always, in case you have questions, feel free to comment below.

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Disclosure: This article is for informational purposes only. It is not intended to be financial advice, and it is not financial advice.

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