Investing can be confusing…so confusing. They are constantly tossing around words like 401K, Roth IRA, 529, ETF, bond, stock, mutual fund, expense ratio, index fund, etc. If your blood pressure went up just reading those words, don’t worry, you’re not alone. As fellow Adventurers, I know you’d rather be breathing in the fresh air and looking at blue sky than staring at a computer screen and learning all about the complexities of investing. So let’s keep it simple (which is always my favorite strategy).
You need to start thinking about your money as little employees. You can invest your money in an index fund earning 7% (on average) and your little employees work hard for you and, what’s even better, they produce even more employees which also work hard for you. Until eventually you have an entire corporation of employees working so hard for you that you don’t have to work at all (Hooray! Financial Independence).
Or you can put your little employees in a savings account, which sounds really nice on the surface. Until you realize that inflation (the purchasing power of your money/how much stuff your money can buy) rises on average about 3% per year (over the last 20 years) and your savings account is earning 1-2%, which actually means that you’re losing money over time. (I learned this the hard way…palm to face.) Those little money employees looked like they were working hard, but really they were just talking about the latest TV show in the break room.
Or you can spend your employees on a bunch of “really nice” stuff that you won’t care about a year from now, effectively sending your employees to work for someone else.
What is an Index Fund?
Okay, so now you’re ready to put your employees hard to work for you. But what is this thing called an index fund? And aren’t you supposed to invest in a 401K, not an index fund? Don’t worry, I’ll explain.
And index fund is a type of investment. If you invest your money in an index fund, you are basically investing your money in a huge number of businesses (putting your eggs in lots of baskets instead of just one). Now many mutual funds do something similar. The problem is that you have to pay a guy to constantly move all your eggs around (which eats into your profit). With an index fund you get the same result as a mutual fund (usually better) and you don’t have to pay the guy either. It’s a win-win.
Here’s a fun graphic that I grabbed from NerdWallet that will show you the difference.
So basically if you invested $1,000 a year for 30 years you’d lose $1,800 in fees with an index fund but you’d lose $15,000 in fees with a mutual fund (that guy charges way too much to move those eggs around).
Now there are index funds that are invested in bonds or stocks or whatever but you’re looking for one that is invested in the whole stock market or that covers the S&P 500 (an index of 500 of the largest US companies). Here are a few examples of some good index funds:
- Vanguard Total Stock Market Index Fund (VTSAX)
- Schwab Total Stock Market Index (SWTSX)
- Vanguard 500 Index Fund (VFINX)
- Schwab S&P 500 Index Fund (SWPPX)
- Fidelity Spartan 500 Index Fund (FUSEX)
- T. Rowe Price Equity 500 Index Fund (PREIX)
- iShares S&P 500 Index Fund (BSPSX)
Alright so index funds are awesome, but how do you invest in them?
Your 401K, IRA, Brokerage Account, Roth IRA, 529, etc., are all just investment vehicles, they aren’t investments. Think of your 401K as the car that you drive around to pick up your investments in. You can throw some bond mutual funds in your car, a few stock mutual funds, maybe some international mutual funds but these are all going to cost you a lot more in gas because they are heavy due to their large expense ratios (how much you pay the guy to move the eggs).
So you need to dump all of those guys out of your car and pick up a nice index fund instead (a total stock market or S&P 500 index fund). Now you generally don’t get to choose whatever fund you want in your 401K because usually your company has a set of funds already set out that you can choose from. So you’ll have to go in there and look. Search for the words “index fund” and “S&P 500.” You can also look at the expense ratio and see which funds have the smallest, which are typically your index funds.
Common Types of Investment Vehicles:
- 401K /Roth 401K: Retirement investment vehicles that you use to invest with through your company. 401K uses pre-tax money that will be taxed when you take it out. Roth 401K uses after-tax money that grows tax free. You are typically penalized if you try to use this money before the set retirement age.
- IRA/Roth IRA: Retirement investment vehicles that you use to invest with on your own. IRA uses pre-tax money that will be taxed when you take it out. Roth IRA uses after-tax money that grows tax free. You are typically penalized if you try to use this money before the set retirement age.
- Brokerage Account: An investment vehicle that you use to invest with on your own. You use after-tax money to invest in the market (hopefully index funds). The money that this money makes is taxable. You can easily open one of these accounts online with a brokerage firm (Vanguard, Fidelity, Charles Schwab, etc.).
- 529: A higher education investment vehicle that you use to invest with on your own. You use after-tax money that grows tax free to use for your child’s after-high school educational costs.
Okay, okay, I know that I said I was going to keep this simple and then I threw all of that at you and I’m sorry. I really did try to keep it as simple as I could while trying to answer common questions you might have. Just think of this as the base for the financial knowledge you’re soon going to have.
Now go hug your kid or roll in the grass or plan your next adventure. You deserve it after that grueling mind hike you just took.
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