If you’ve ever listened to Dave Ramsey or ventured along the journey of personal finance, you’ll hear a lot of people talking about the importance of an emergency fund. An emergency fund is money that you have readily available, usually in a savings account, in case you incur some type of emergency or unexpected expense. If the air goes out in your home, your car breaks down, or heaven forbid you lose your job, you can quickly access money in your emergency fund to cover expenses.
Many folks have found emergency funds to be quite useful. We can’t always predict when we will incur various expenses but most of us know that they will inevitably occur. Emergency funds help lessen the shock. If the brakes need to be replaced on your car or your iphone stops working, yes you may be annoyed and inconvenienced, but with an emergency fund, the expense itself stings a little bit less. When you know you have money to cover the costs, you tend to be less stressed or bothered by these unexpected expenses.
Is an emergency fund necessary?
For those of us who are still building wealth or who may be 1 or 2 paychecks away from being unable to pay our bills, then yes. An emergency fund is necessary. If we are going to build wealth or at least become financially stable, we have to minimize our need to take out high-interest consumer debt, like credit cards, when expenses arise. One way to do that is to save money in advance, via an emergency fund.
How much do you need?
Like a lot of things in finance, it depends. How much money do you already have saved or invested? How reliant are you on your paycheck to pay your bills? How stable is your job? How consistent is your income? Do you spend most of your paycheck or do you frequently have money left over?
The general rule of thumb for young professionals is to start with $1,000. $1,000 is usually enough to cover minor car repairs, a new phone, a laptop, or a last-minute flight home. As prices have risen lately, perhaps $2,000 is a more accurate number. Regardless, the point is to start off with a reasonable amount to cover expenses and unexpected costs.
The next step, and where most people land, is to save up 3 to 6 months’ worth of expenses. Notice I said months of expenses, not full paychecks. You need enough to cover you in case you lose your job unexpectedly, have to quit, or get laid off. The importance of having this type of emergency fund was ever so present in March of 2020 when the world shut down from the COVID pandemic and even folks with stable jobs, like doctors, were forced to take pay cuts or close their clinics for months at a time. Having money that you can tap into during unexpected times like this is key. The exact amount is up to you.
How do you save up this money?
Unless you have an extremely high income, it may take time to save up this emergency fund. And that’s okay. Most people have to save money from several months’ paychecks in order to reach their desired amount. When I first started my emergency fund, I wasn’t making much money and I was always tempted to spend that money on something else. In order to prevent that from happening. I had a certain amount from each paycheck deposited into an entirely different checking account. I used some of the money in that separate account to pay down debt and left the rest of the money in the account to build over time as my emergency fund. Before I knew it, I had saved $1,000. It increased even more from there.
To summarize, emergency funds can be quite useful, especially when you are starting out in your career. Having money to use in emergencies prevents you from having to take out high interest credit cards when expenses occur unexpectedly. Tell me, have you started saving for an emergency fund?
I Paid off $10K in Credit Card Debt as a Resident, here's how
Like many other resident physicians, I had credit card debt when I started working. I accumulated the bulk of it during my postgraduate days living in a high-cost-of-living area when I was 22, but I added to that amount when I had to pay for med school applications, secondary essay fees, and travel costs to interview. During my time in med school, I lived off student loans, but during the 3 months between my med school graduation and my first paycheck as a resident doctor, I had accumulated even more. I needed money to move to a different state, pay my first month’s rent, and cover things like food and gas while I was awaiting my first residency paycheck. I didn’t have a spouse to help and my parents, while loving, didn’t give me the money I needed either. Before I knew it, I had $10,000 in credit card debt. Fortunately, I was able to pay this off in a year a half after starting residency. Here’s how:
I realized I didn’t like being charged interest on money I’d already spent. My first temptation was to delay paying it off. I was only making around $60,000 per year as a resident so I didn’t have a lot of extra money to spare. I knew that my income would increase when I finished residency, so it seemed logical to just wait to pay it off when I got the income boost. That changed the minute I logged into my online bank account. I was shocked when I realized I was being charged $100/month in interest. When I looked further, I saw that the interest rate on my credit card was 12%. This meant that I was going to pay an extra $1,200 a year in interest until I paid off the debt. Seeing how much interest I was being charged motivated me to pay it off quickly, even while I was still in residency.
I decided to pay it off in less than 2 years. As most folks know, a resident’s salary is not very high. Paying off $10,000 in credit card debt when you’re only making $60,000 a year can be tough, but I made a decision to do it. I knew that if I delayed paying it off, each dollar I was paying in interest was less money I could use to invest and build my net worth. Although I could have dragged the payments out during my entire time in residency, I really wanted to pay it off sooner so I could have the freedom to invest more money. This motivated me. I made a goal to pay it off in 2 years. (One year would strain my budget too much but 2 years gave me a realistic goal I could look forward to).
I lived with a roommate to make extra monthly payments. As a resident, I knew I would be working a lot. Although I really wanted my own living space, I knew I wasn’t going to be home very often to enjoy it. I figured I might as well share the space with a co-worker and use the money I saved in rent to pay down my debt faster. So that’s what I did. I got a 2-bedroom 2 bathroom apartment for $1700 a month. My roommate split the rent, electricity, cable, and internet bills with me. Instead of paying almost $2000 a month for rent and utilities, I only had to pay half of that cost. Saving nearly $1000 a month in living expenses gave me extra room in my budget to not only pay down my credit card debt but to also save a little money in cash to start an emergency fund.
I set up automatic deductions to pay $500 each month. This seems aggressive but $500 was my number. I knew I wanted to pay this exact amount each month, but I also knew I couldn’t be trusted to make this payment of my own volition. Thus, I had 20% of my net pay go to an entirely different checking account, which I called my “wealth building account.” I set up a $500 deduction from this account to my credit card each month and let the remainder of the money build up in that account as my emergency fund. Because this money was deposited and deducted from an entirely different account, I never saw the money in my main account and thus didn’t miss it too much. I got used to living on the remaining 80% of my net pay. Doing this did make me feel more “broke” than some of my co-residents who had more disposable money to spend each month, but it made me feel good to know that I was paying down my credit card debt and building up my emergency fund at the same time.
I used money from my tax refund and the first stimulus checks to pay it off. When I was in my first year of residency, coronavirus hit. While this was devastating for many reasons, the silver lining of this occurring meant I got a stimulus check. I used most of the money I got from this stimulus check and my tax refund in early 2020 to make extra payments on my credit card debt. While many other folks went online shopping with their money, I was paying down my debt. When I got the second stimulus check, I was able to pay off the credit card debt completely. A goal I had set for 2 years, had been accomplished in 18 months. I was thrilled.
I was diligent about not accumulating more debt once the balance had been repaid. Making that final payment to my credit card felt great, but I’d be lying if I said it lasted forever. Ironically, I was very tempted to charge even more expenses on my credit card, especially when I wanted the newest iphone, newer clothes, or the ability to take more vacations with my friends. Many people argued that I could just charge the money on my credit card and pay it off when I became an attending, but I chose not to go that route. I hate debt and the more debt I had the less I could invest to grow my net worth. Plus, I didn’t want to set bad habits. As someone who blogs a lot about personal finance, I know that finance is more about changing behavior than being good at math. If I got into the habit of buying things that I couldn’t afford now, I would likely buy more than I needed, accumulate substantially more debt, and have a harder time being debt free as an attending. I wanted a different life.
What about you? Are you developing bad habits by purchasing things you can’t afford using debt or are you willing to do what it takes to pay down your debt quickly and start investing, even while you’re in training or making the median income? If I can be credit card debt free, so can you.
6 Reasons to Understand How your Money is Invested
I love to read books, listen to podcasts, and watch videos on personal finance, but some of you may prefer to hire someone to take care of that for you instead. And that’s okay. Whether you decide to manage things yourself or get a financial advisor, it is vital that you understand the basics. Don’t blindly follow someone else’s investment plan without fully understanding it and don’t naively trust a financial advisor to have your best interest at heart. No one is going to care more about your money than you. Before this year ends, make sure you fully understand what is happening with your money. This is why:
1. To ensure you are not being taken advantage of. Many doctors and young professionals who are unaware of how their money is invested and know very little about personal finance get taken advantage of by people they thought had their best interest at heart. They may overpay for things, have their money invested the wrong way, or be overcharged for assistance in managing their assets. When people know you have more money, they tend to raise their prices and fees because they assume “you can afford it.” Having some knowledge of personal finance will allow you to better discern if you are getting charged a fair price for good advice, or not.
2. To ensure you aren’t being charged high fees that decrease your investment returns. In order to have your money grow over time, it needs to be invested. When you invest money, you usually do so by purchasing assets that will increase in value over time. The cost of acquiring those assets can vary but the key is to make sure the fees you are being charged to have those assets are not too high. This is especially true when it comes to real estate and the stock market. Overpaying for a home or investment property can cause you to lose money quicker than you think. Investing in mutual funds (groups of stocks or bonds) with high expense ratios can cut into your profits and minimize the growth of your money. For example, if the average mutual fund has a yearly increase of 8% per year but inflation is 4%, the fund fee is 1% and your advisor fee is 1% then the growth of your money is really only 8% minus 6% which is 2% per year. We cannot control inflation but minimizing the fees we are charged on our investments is within our control. Be aware of what you are being charged for certain investments and make sure it isn’t too high.
3. To ensure you are not invested in things that underperform the market. Another disadvantage of not understanding personal finance is having the wrong investments. Although personal finance is personal, double check that you are actually making good investments, which I define as things that have a high chance of increasing in value over time. There are lots of “good” investments but there are also investments that underperform the market or change in value too frequently to be useful. Learning about personal finance helps ensure that you are investing in things that will increase at an appropriate rate over time.
4. To ensure your investments aren’t just things that provide bonuses and commissions to your advisor. Believe it or not, there are some advisors who will use your money to enrich themselves. They will come to you claiming to help, all the while investing your money in questionable ways and buying products that result in a large commission to themselves at your expense. Although some are sneaky, others have simply been trained or groomed to believe that the things they sell are good. They attended a seminar or class that taught them all the potential benefits of certain products without mentioning the drawbacks of the investments they offer. As a result, they come to you with good intentions but bad information. They may try to talk to you about the benefits of whole life insurance and conveniently fail to mention the large commission they get for selling you the policy. They may suggest that you purchase an annuity but fail to mention the high fees and lifelong commitment to suboptimal mutual funds it requires. Having some knowledge of personal finance will help you avoid this and ensure that your advisor isn’t charging you money to enrich him or herself.
5. To ensure your investments align with your risk tolerance and investment goals. Another perk of knowing about personal finance and investing is being able to ensure that you are investing in ways that give you a good chance to make a profit (with little fees) with minimal risk. You want to make sure you aren't invested too heavily in one thing. It's also important that you plan for the unexpected. If you switch to a low paying job, your child care expenses increase, or the stock market or real estate industry crashes again, do you have room in your financial plan to handle it? You need to take some risk in order to make a profit but be careful not to take too much risk. You don’t want to lose all you have over one unexpected event. Diversify your investments, buy assets in different industries and consider using the combination of stocks bonds and real estate to protect yourself against the unexpected.
6. To ensure that you know your true net worth. As you continue investing and building wealth you should be keenly aware of not only what you are investing in but also where you are in your journey to financial independence. This means you should be able to calculate your net worth. If you stopped working today, how much money would you have? What is the total amount of your assets (the things you own) minus your liabilities (the debt you owe)? If you didn’t make any more money, how long could you still afford your current lifestyle? Are you reliant on your next paycheck or do you have enough money saved and invested to continue to live life and function as you do now? Part of being money savvy is not living paycheck to paycheck. It’s not being dependent on your job. It's being aware of where you are in your wealth creating journey. What is your net worth?
4 Reasons I Started Investing in the Stock Market
When you make the decision to invest money, you will have lots of choices. You can buy stocks, bonds, and mutual funds. You can venture into real estate, get some cryptocurrency, or purchase gold. Despite all of the options, I decided to start investing through the stock market by purchasing index mutual funds. Here’s why:
1. No barrier to entry. Unlike buying real estate which usually requires a 5 to 6-figure sum as a down payment or a high net worth to establish yourself as an accredited investor, getting started in the stock market was fairly easy. I logged onto the online portal for my job and clicked a button to start contributing to my work retirement account. I began by investing 3% of my salary and increased the percentage every few months until I got to my target of 10%. The next year I opened a Roth IRA to purchase even more index mutual funds and was able to set it up with one phone call. Some of my friends simply downloaded the Robinhood app to get started. My point? Investing in the stock market is a simple thing to start doing. No high fees, specific net worth, or long waiting period required.
2. Doesn’t require lots of specialized knowledge. Some people choose to invest in collectibles like art or specific commodities like gold or natural gas. They purchase expensive items they believe will increase in value over time or make various investments to enhance various energy sources. Although there is nothing inherently wrong with this practice, investing in collectible items and commodities usually requires a specific skill set. If you purchase art, you must have specialized knowledge of that industry so you can understand how much the art is truly worth. If you invest in commodities like gold or alternative energy sources, you must understand when and how the item or investment increases in value in order improve the chance that you’ll make a profit and decrease the chance that you will lose money. For those like me who aren’t art gurus and don’t have specialized knowledge of specific industries, investing in commodities and collectibles may not be the wisest thing.
3. Provides tax savings and liquidity. As a young professional who invests a good chunk of my income and pays a decent amount in taxes, I want investments that can help lower my taxes each year. Along with tax savings, I also want liquidity. Although my plan is to keep the money in investment accounts for decades, I want a back-up option as well. In other words, I want the ability to take my money out of the investments fairly easily if some large, unexpected event occurred and I happened to need cash quickly.
Investing in the stock market via index funds through my Roth IRA and my work retirement account provides me with both of these perks. My work retirement account allows me to use a portion of my income to invest in index mutual funds in a way that saves me money in taxes each year. My Roth IRA allows me the liquidity I need. It allows me to take my contributions out of the account at any time serving as a backup emergency fund that can give me access to cash fairly easily if I needed it.
4. Steady growth with lower risk. Unlike folks who pick and choose individual stocks to purchase or who try their hand at stock “options” or “puts,” I invest in the stock market much differently. Instead of trying to predict which companies’ stocks will go up and down in value over time, I purchase index mutual funds. Buying an index mutual fund, like the Vanguard Total Stock Market Index Fund, means that I own a small percentage of stocks from almost all of the companies in the country. I have a little bit of Apple, a little of Tesla, a little of Google, but I also have a little of thousands of other companies too.
Although the exact value of the index mutual fund can vary a bit day-to-day, on average the total stock market index fund tends to increase in value by about 10% each year. This allows for steady growth over time with very little effort on my part. I don’t have to learn a bunch of different skills or read up on various companies. Plus, unlike those who invest in cryptocurrencies like Bitcoin, the price of index mutual funds doesn’t vary as much. This makes index mutual funds a bit more predictable and easier to plan around. With index mutual funds, I can better estimate when I’ll reach a certain financial milestone because the average growth per year is fairly consistent (usually around 10%). When it comes to my money, I like consistent steady increases.
My point? When I started investing I did so by purchasing index mutual funds in the stock market. Nowadays, I invest in a little real estate as well. But I know people who invest much differently. I have family members that invest in cryptocurrencies, friends who own gold, and college professors who collect art. We all have reasons for investing the way we do. There is no one-size-fits-all. However, for most folks looking to make their first investment, buying an index mutual fund may be a good place to start.
6 Financial Mistakes Most Residents Make in Training
As resident physicians most of us are just trying to keep our heads above water. While our time in training helps us become better doctors, many of us do some unwise things in terms of finances. Here are 6 of the top financial mistakes residents make in training:
1. Using the promise of future money to justify unwise purchases. I’ve seen numerous residents buy luxury cars and other expensive items during training. Although some have enough wealth or savings to afford these items, many others do not. There is nothing inherently wrong with having nice things, but going into debt to buy something you don’t need may not be the wisest decision, especially while you are in residency. Just because our salaries are set to increase once we finish training does not mean we should accumulate more debt before we get to that stage or finance a car with high monthly payments. Many of us already have six-figure student loan debt. Adding a high car loan to that amount at a time when we are only making around $60,000 a year can decrease our monthly cash flow and delay our ability to build wealth.
2. Not having a plan for their student loans. Some residents, especially those who live in high cost of living areas, find it challenging to cover their monthly expenses on their resident salary. As a result, they choose to defer their student loan payments until they become an attending. Although this may seem like a smart way to improve your cash flow, pausing student loan payments causes even more interest to accrue on your loans, forfeits interest subsidies you may qualify for, and prevents you from meeting qualifications for the public service loan forgiveness program. Instead of deferring your loans, come up with a plan. Look at the various income-driven repayment options and pick one you can afford. Fill out the employment certification form and take advantage of your time in residency in which you can make low payments that still count toward public service loan forgiveness.
3. Failing to ensure themselves against catastrophe. Many of us are healthy and tend to assume that things will work as we plan. Unfortunately, life has an inevitable ability to surprise us with situations we didn’t see coming. One of the best things we can do as residents is protect ourselves and our future income by setting up an emergency fund and getting disability insurance. Saving up money in an emergency fund will give us a way to cover unexpected expenses without having to take out debt. Getting an individual disability insurance policy, outside of what is already offered through our residency, will provide give us a steady monthly income if we happen get disabled from a car accident, diagnosed with a progressive medical condition, or suffer a mental health disorder that prevents us from working full time as physicians.
4. Racking up high-interest credit card debt. Many residents have such a large amount in student loans, that they have become immune to debt. They assume they can just pay it off when they get their attending jobs. Because of this thinking, many residents purchase things before they can fully afford them and end up taking out even more debt during training. They charge vacations, large purchases, travel expenses, and other unnecessary items on credit cards that end up costly substantially more money in the long run. Although we may be able to pay off our debt as attendings, it still accumulates interest while we are in residency. Plus, money spent towards credit card bills in training is less money we have available to invest and build our net worth. If you absolutely need money in training to cover things like moving expenses or childcare, then take out a low-interest personal loan with a plan to pay it back as soon as you are able, but try your best to avoid high-interest credit card debt.
5. Not using retirement accounts to build wealth. Many residents are not taught the basics of personal finance in training and may not know or understand the benefits of investing early. Perhaps they have heard of a Roth IRA or are aware that there is an option to contribute to the retirement plan at their residency, but they consider retirement a long way away and do not know that taking advantage these accounts in training can jump start their ability to build wealth and create the life they want. The truth is, because of inflation, we cannot save our way to wealth. We have to invest. Because of the power of compound interest, the sooner we invest, the sooner we build our net worth. One of the best ways to build our net worth is by investing in the stock market on a consistent basis. Because of the tax benefits, asset protection, and retirement matches from our job, investing through retirement accounts is one of the best ways to build wealth.
6. Buying a home without considering the full cost. There’s nothing inherently wrong with purchasing a house, but I’ve noticed that many residents do it for the wrong reasons. They incorrectly assume that if their projected mortgage payment is less than their estimated rent payment then they should buy a home. However, comparing rent prices to mortgage prices will give you an incomplete picture. There are transaction fees involved in buying a home (like attorney fees, inspections, and appraisal costs) that can add thousands more dollars along with the added costs of maintaining a home (like homeowner’s insurance, property taxes, and repairs) which can easily add another $400-500 to your monthly mortgage amount. The truth is, even if the rent price is higher than the mortgage price, the added fees associated with home ownership can still make renting cheaper. Be sure to count the full cost when deciding to rent vs buy.
My point? As resident physicians we aren’t expected to do everything right but avoiding these 6 financial mistakes will help ensure that we are setting ourselves up for financial success when we become attendings.
9 Reasons Doctors Aren't as Rich as You May Think
Many people think doctors are rich. While many physicians have high salaries, I can tell you firsthand that a lot of doctors are not as rich as everyone thinks. Here’s why:
1. Med School Debt. Like other young professionals, many doctors have student loans. But unlike undergrad, medical school is expensive. In fact, most med students take out at least $30,000, per semester of medical school. The average medical student loan debt is over $240,000 by the time we graduate and this balloons to over $300,000 by the time we finish training and account for the interest that has accrued. It’s a lot harder to become rich when you start off with a net worth of negative $200,000 or $300,000 after graduating from medical school.
2. Prolonged Schooling. Doctors spend many years in school. Many of us start school at age 5 and don’t finish all the schooling and training needed to be a doctor until we are in our late 20s or 30s. Because of this prolonged schooling, doctors don’t start earning money until much later in life. While people in other professions have full time jobs with benefits and guaranteed salaries in their 20s, many doctors are living off of student loans. This means we can’t earn money, save money, or invest money in our twenties like many other people can. As a result, we have a delayed start to building our net worth.
3. Residency and Fellowship. After medical school we spend years in additional training working as residents physicians in which we are paid an average of $60,000 a year to work 60-80hours per week. In other words, we are full-time doctors, with full medical licenses getting paid a little more than minimum wage per hour. And this is mandatory. Every practicing physician must go through residency. The length of residency depends on the medical specialty, but it ranges from 3 to 7 years. Once residency ends, many physicians go through additional training called fellowship which means they spend another 1 to 3 years getting paid this lower rate.
4. Specialty Hierarchies. There are wide variations among physician salaries after residency. Pay can range from $120,000 a year to $600,000 a year and beyond. The amount of money a physician makes is heavily dependent on one’s primary medical specialty. Specialties that do more procedures (like surgery and radiology) tend to generate more RVUs (revenue value units) which results in higher insurance reimbursement rates than specialties that do fewer procedures like family medicine and pediatrics. Specialties like plastic surgery and dermatology that are more cash-based and offer cosmetic services tend to generate higher salaries as well.
5. Taxes. Once doctors finally finish training and start making higher salaries, they are often in the highest tax brackets. This means a large chunk of their earnings is deducted from their pay before it ever hits their bank account. Unlike many of the rich, who are able to shield a lot of their income from taxes by making real estate investments or business dedications, many doctors are employed as W-2 workers which is taxed at a higher rate. Along with higher tax rates, and fewer tax shields, doctors are often phased out of many of the subsidies that benefit the middle class and are ineligible for tax breaks and refunds enjoyed by the rest of the population.
6. Overspending from Delayed Gratification. After spending many years in school and training, doctors have a great deal of delayed gratification. Many of us want to buy a home, start a family, purchase a new car, take a nice vacation, and make other large purchases. After so much delay, it can be hard to resist the urge to do all of these things at once. Many physicians finance expenses, take out debt, and purchase things before they have all the money needed to do so. This exponentially increases the debt we already have and delays our ability to build wealth.
7. Mid-level Influx. Physicians cannot ignore the impact of mid-level providers. While nurse practitioners and physician assistants are valuable providers who can help increase access to care, they have been used by healthcare corporations as a cheaper alternative to care. Although physicians and mid-level providers are both immensely valuable, the influx of mid-levels has decreased the job options and lowered the pay range for some physicians. For example, instead of hiring two physicians to work in an urgent care, a company may instead hire one doctor and one mid-level provider.
8. Big City Saturation. Physician salaries vary widely in certain parts of the country, but not in the way one might think. In most jobs, people in larger cities get paid more to compensate for the higher cost of living. The opposite tends to be true in medicine. Because larger cities usually have more entertainment options and educational opportunities with large hospital systems that have more jobs for physicians in niche specialties, many doctors want to live in or near a major city. This creates physician oversaturation in these areas. Because the supply of doctors is so large in big cities, the demand for doctors in those areas decreases which results in lower salaries. As a result, doctors tend to get paid less when they move to larger cities. Along with taking a pay cut to live in a desirable area, many of these big cities often have a higher cost-of-living and tax rates which further decrease a physician’s take-home pay.
9. Lack of Financial Literacy. Despite our intelligence and skill when it comes to medicine, many physicians are never taught about money. Physicians spend years in school, often without ever having a salaried job, then go through residency where they are overworked and underpaid. They then finish training with a massive pay increase and zero guidance on what to do with their money. Many physicians spend too much too soon, and fail to save or invest enough of their income to build wealth over time. Unfortunately, many who doctors who seek professional help by hiring a financial advisor are often taken advantage of. Many are charged high prices for bad advice and are often tricked into purchasing inefficient financial products or investing money in subpar ways which further delays their journey to building wealth.
Thus, doctors aren’t as rich you may think. Some of it is our own fault, some of it is a system failure that impacts us greatly.
Tell me, what are some reasons you think doctors aren’t as rich as everyone thinks? Do you have any ideas on what we should do to overcome these hurdles?
7 Principles to Help You Start Investing
We all have friends and family members who are investing money. Whether it’s stocks, bonds, real estate, or cryptocurrency we all know a few people who are investing. And this is a good thing.
Why? Because we can’t save our way to wealth or financial freedom. We must invest.
Although savings accounts may be “safe,” keeping all of our extra cash in those accounts may not be wise. Money sitting in a savings account won’t grow fast enough or accumulate quickly enough to allow us to meet our money goals. Plus, because of inflation, things cost an average of 2-5% more each year. This means that one dollar today will only be able to buy you 95cents worth of stuff next year. As things increase in cost each year, the amount of things you can buy for one dollar decreases, so you lose more and more purchasing power each year. In order to overcome this “inflation effect” we must find ways to make our money grow.
This brings us to investing.
Investing is when you purchase assets or things are likely to go up in value. Buying assets allows our money to make more money over time.
But… you must know what you’re doing.
Investing money without fully understanding what you are purchasing and how it works can cause you to lose money quicker than you think. Instead of feeling like you have to know everything about every investment, commit to learning a few of the basics:
Principle #1: One of the easiest ways to begin investing is in the stock market.
Unlike real estate investing which has lots of moving parts and requires a unique skill set and high startup capital or investing in cryptocurrencies that use newer technologies that can challenging to understand or who’s intrinsic value changes drastically, investing in stocks and bonds is often much easier.
Principle #2: When investing in the stock market, it is much safer to seek average profits with minimal risk of losing money than to aim for extraordinary profits with a high risk of losing money.
In order to obtain average returns (8-10% per year) with minimal risk, it is wise to invest in diversified index mutual funds. Let’s break down what this means:
A mutual fund is a group of investments (like a group of stocks or a group of bonds). Instead of buying one stock or one bond in a specific company like apple or tesla, buying a mutual fund means that you purchase a group of investments (that contains a percentage of stocks from apple and tesla and many other companies altogether). In other words, instead of one whole stock, you have a mutual fund that has a little piece of many different stocks.
An index mutual fund is a specific type of mutual fund (group of stocks or bonds) that follows an index. This means the amount and percentage of stocks that are contained in this group are similar to those that are tracked by other validated measures and meet a certain set of requirements. Examples of indexes are: the Standard and Poor 500 also called the S&P 500 (which is a list/index of the largest 500 companies in America). Because these mutual funds follow an index, they tend to be well diversified, which means they contain many stocks from different companies in various industries.
Principle #3: Investing in diversified index mutual funds has less risk than buying individual stocks.
If the value or stock of one company decreases, then stock in the other companies can lessen the impact of that decrease. Thus, with an index mutual fund the value of your investment tends not to change as often. Because you are have a percentage of stock in many different companies you have room to capture increases in stock value from many different companies at the same time. It is impossible to predict which companies will have stock that increases in value each year instead of staying the same or decreasing in value. Index mutual funds offer a shield of protection along with added opportunities for growth that combat this uncertainty. Instead of having to buy individual stock in 500 companies, you can just buy the index fund and have a percentage of stock from all the companies for a much cheaper price. If the value of apple goes up, so does your investment. If the value of another company within that index fund goes up so does your investment.
Principle #4: Pick some of the most common index mutual funds and realize that different brokerages can have similar index funds that are called different names.
Many people may understand in theory what an index mutual fund is, but they may not know which one to invest in. In order to combat this problem many people invest in a lifecycle or target retirement funds. They may even pick a simple 3 fund portfolio (which means they invest in 3 different indexes at the same time). The goal is to invest in the index funds that have done the best over time, that are validated, that tend to have the highest returns year after year. That would be a combination of 3-4 different types of indexes:
A Total United States Stock Market Index (an index that buys a percentage of all of the stocks in the United States)
A Total International Stock Market Index (an index that buys a percentage of the stocks from companies all around the world)
A Total United States Bond Index (an index that buys a percentage of almost all of the bonds in the United States)
A Total International Bond Index (an Index that buys a percentage of almost all of the bonds from across the world)
You can get a version of each of these types of indexes at various brokerages (firms that allow you to buy stock). For example, the Total US Stock Market Index Fund at the Fidelity brokerage is listed under the symbol FSKAX and the Total US Stock Market Index Fund at the Vanguard brokerage is listed under the symbol VTSAX.
The percentage that should be invested in each of these indexes depends on the person.
Principle #5: The general rule of thumb is to have most of your money invested in stock index funds and a smaller percentage in bond index funds.
I have about 90% of my work retirement money invested in stock indexes (with 60% in the U.S. Total Stock Market Index Fund and 30% in the International Stock Market Index). I have the remaining 10% of my work retirement fund invested in bond indexes (with 8% in U.S. bonds and 2% in international bonds). What is right for me may not be right for you, so you should determine your own percentages.
Once you know why you must invest and you understand what to invest in, you must then understand a couple more things:
Principle #6: The stock market will experience ups and downs, but over the long haul, it continues to increase in value. It is better to invest consistently over time than to try to pick and choose the best times to buy and sell your investments.
Continuing to invest consistently despite the market fluctuations (changes in stock values from day to day) will prove to be more valuable to you than trying to “time the market” or invest only at certain times when the market is reacting in certain ways. It is more lucrative to buy when things are priced low (when the market is experiencing a downturn) and sell when things are priced high (so you can maximize your profit) but trying to time the market is hard to do since no one can predict the future. Attempting to time the market often results in lower profits than if you had just invested consistently over time because it’s nearly impossible to which days certain stocks will be low in value vs high in value.
Principle #7: Your money makes more money over time via compound interest so investing consistently over many years will help you to build wealth and meet your financial goals.
It often takes years to reach that first milestone of $100,000 but much less time to reach the next milestone of $200,000. Time is your friend. Trying to get rich quick often results in losses and can lead to poverty and debt. Be patient and consistent. Invest.
Be Weary of Annuities
As a young professional who will make a lot of money over the course of your career, you may be approached by a financial advisor. Although some advisors can be great assets, others were trained as salesmen and may not have your best interest at heart. They may overcharge for advice or worse, convince you to purchase expensive investment products you may not need. One of the products you should be weary of purchasing is an annuity.
What is an annuity?
An annuity is a type of investment product you can purchase from an agent at a brokerage or life insurance company. You pay a set amount of money to the company (via a lump sum or in monthly payments), the company invests that money on your behalf. After a certain time period, the company will then return the money you gave them back to you in smaller fixed monthly payments (usually for the rest of your life) with interest. In other words, you give the company your money now to invest and the company returns your money back to you later (in small payments) with a certain amount of interest. It some ways, it is similar to a bond (with many more fees attached, as we will discuss below).
When it comes to annuities, there are different types. The main types are immediate annuities and deferred annuities. With an immediate annuity, you pay a lump sum for the annuity and the company starts paying you in monthly installments immediately. There is no waiting period between the time you purchase the annuity and the time you receive your first monthly payout. With deferred annuities, there is a waiting period. You may pay for the annuity with a lump sum or with fixed payments, then you wait a number of months or years before you get your first payment. Along with the timing of when you get your first payout, there are also variations in the amount of your payout. Some annuities have fixed payouts in which you receive the same amount of money each month. Other annuities have variable payouts (in which your monthly payment changes based on how well or how poorly your money is being invested). Lastly, some annuities have payouts that follow a certain index (like the S&P 500).
Why do some financial advisors recommend them?
It may provide a guaranteed income. By purchasing an annuity you get a set amount of money no matter how long you live. If you don’t know much about investing and want to virtually ensure that you will have a certain amount of money each month in retirement you can buy this product. Financial advisors may also state that this product is better than investing in taxable accounts because the profits are tax deferred until you start getting withdrawals/payouts. Annuities are sometimes purchased by retired individuals who fear they may outlive their retirement savings and want to guarantee themselves a monthly payout for the rest of their lives.
Why you should be weary of an annuity?
The agent and company takes a large portion of your investment returns
In order for the company to be able to guarantee you an income for the rest of your life they have to make sure you give them enough money to cover the cost of the payout they will give you while also netting themselves a profit. They need to be able to pay you and make money for themselves. Companies who sell annuities are businesses not charities. Ensuring a profit for themselves is how they stay in business. Unfortunately, this profit is at your expense. While a small cut is reasonable, many of the agents and companies who sell annuities take rather large cuts of your profit, often up to 10% of the total value of your payout.
The money you loan them is invested in inefficient ways which reduces your profit and payout
Along with the agent and company taking a rather large portion of your payout, the payout that you do receive is often not as a large as it should be. Why? Because the money you put into annuity is usually invested in inefficient mutual funds that have a track record of underperforming the market (getting lower investment returns than the average). Plus, many companies charge high expense fees on the profits you do make. In other words, you get lower investment profits and have to pay more even more money in fees for them.
Purchasing an annuity is inflexible and binding.
If you want to take money out of the annuity early (to get payouts sooner or increase the amount of your payout temporarily to pay for a large expense), it is extremely costly. You would have to pay a high percentage in taxes to take money out sooner. Plus, if you want to sell the policy or get rid of the policy at any point, the company will charge you an exorbitant fee (often 10% of the value) to “surrender it.” Lastly, once you start getting your fixed payments, you have to pay taxes on this income at your ordinary income tax rate which tends to be much higher than the capital gain tax rate you would have been charged had you simply invested your money in an taxable account yourself instead of purchasing/investing money in an annuity.
What is a better alternative to an annuity?
Prioritize retirement accounts like your work 403b and Roth IRA. Through employer-sponsored retirement accounts you can contribute money to invest for retirement in a way that lowers your taxes each year. You may also get extra “free” money to invest if your job offers a retirement “match” (extra money employers put in your retirement account free of charge as a bonus for choosing to invest). Along with those two perks, prioritizing retirement accounts lowers your taxable income which can decrease your student loan payments. Retirement accounts like a Roth IRA, even offer a wide variety of investment options and allow you to get tax-free growth on your profits. A Roth IRA also allows you to take out your contributions at any time instead of having to wait until you retire, providing more flexibility and serving as a backup emergency fund should unexpected expenses arise.
Invest money in index funds via taxable accounts (after maxing out retirement accounts). Instead of purchasing an annuity, you can simply open a brokerage account and invest the money in low-cost index funds. Doing so, will allow you to invest even more money, on top of what you already invested in your retirement accounts, to build your net worth sooner. With taxable accounts, you can withdraw the money at any time and your profits will be taxed at lower rate.
My point? Annuities may seem like good idea but many young professionals should be weary of them because they tend to be costly, expensive, and inflexible. The money in them is often invested in suboptimal ways and the agents and company who sell the policy take a large chunk of your money. Instead of opting for an annuity, invest money in low-cost index funds since they have low fees, good profits, and lots of diversification that decrease your risk of losing money. When investing in low-cost index mutual funds, you may first want to prioritize doing so through retirement accounts (due to the tax advantages) then opening up a brokerage account to invest the rest. Unless you are currently retired and fear you may outlive your savings, annuities may not be the best investment option.