Each entrepreneur I know who has sold a business for millions of dollars lost money investing. They buy real estate because they can see it; they invest in friends’ startups because they can talk to the owners; they speculate on egregiously overpriced stocks because their friends bought those stocks. At least two thirds of the time, their investments end poorly. More gray hair, less money.
What to do is simple–you’ve heard it before. Yet sound advice can get lost in the noise created by those who desire to make money off your money.
1. Pay Off Your Credit Cards
The average interest rate charged by credit card companies on outstanding balances is 23%. Over the last 20 years, investing in U.S. stocks has returned 8% per year1. Borrowing money at 23% to invest it at 8% is not good for one’s health.
In 2000, MIT researchers offered MBA students the opportunity to purchase tickets to a basketball game, Boston Celtics versus Miami Heat. Each participant was given a sheet on which to write his or her bid for the tickets. The highest bidder would win the tickets, but would only pay the price bid by the second highest bidder. Participants were unaware that some sheets required students to pay by cash and others by credit card. The researchers discovered that students in the pay-by-credit card group were willing to pay 64% more than a similar student in the cash group. The title of the study: “Always Leave Home Without It”.
You might be wondering, “What about all the points?” According to Bankrate survey data2, half of Americans carry credit card debt–the average is around $6,0003. A typical credit card offers rewards of one to five percent on purchases. A typical American spends around $1,500 per month with a credit card–this equates to $15 to $75 in rewards ($1,500 x 1-5%)–and pays at least $83 per month ($1,000 per year) in credit card interest. Most Americans lose money with credit card points. Even for someone who pays their balance on time each month, if that credit card user spends just 25% more using a credit card than if they were to only use cash for purchases, that’s an extra $300 per month in spending–to receive $15 to $75 in rewards.
With your $100,000, first pay off your credit cards; you can’t grow wealth paying 23% interest. Then, if you want to go a step further, which is what I recommend, cut up and cancel your credit cards.
2. Spend Less Than You Make
“How do you become a millionaire?” Richard Branson was once asked. He joked, “Become a billionaire, then buy an airline.” No matter how much income one earns, it’s possible to overspend.
While spending less than you make isn’t something you do with your $100,000, it keeps your money from dwindling away.
If you invest your $100,000 at 10% per year, in 15 years you’ll have $417,725. But, what if you earn $75,000 per year–around $5,000 per month after taxes–and overspend your income by 10% ($7,500 per year)? After 15 years, you end up less than half of what you would have earned without withdrawing from your investments. That assumes you don’t have to sell your investments at the worst possible time, such as during a severe market drop, which could hurt your returns further. Before you invest, live within your income.
Some individuals in the FIRE (Financially Independent Retire Early) community retire young by saving large portions–as high as 75%–of their income. Saving a large portion of one’s income is the most accessible path to financial independence because it’s the most in one’s control. A person dedicated to saving can live with roommates, get rid of their car (and car insurance), eat at home, and pursue cheap or free hobbies.
I took a different path. I started 20 businesses in my first two years as an entrepreneur. I kept learning and testing and working until I significantly increased my income. Rather than saving a large portion of a modest income, I saved a modest portion of a large income. With this approach, I reached financial independence in my mid-twenties.
Regardless of your income or what portion of it you save, the foundation of financial success–and a requirement to make your money last–is to spend less than you make.
3. Set Aside Six Months of Living Expenses
I geeked out about Warren Buffett with a fellow devotee at a gathering for entrepreneurs recently. The fellow attendee commented that other members of this group make fun of him for keeping all his cash in his personal checking account. I told him he could earn $20,000 to $40,000 per month by putting that cash in safe short-term loans to the U.S. government (treasuries)–like Warren Buffett. Yet, I think there’s wisdom in his unconventional approach to keeping so much cash in a checking account that earns him little interest.
Simple is best. Humans have a tendency to fixate on minutiae, while missing what matters most. Allocating your cash to the perfect mix of investments won’t matter if you have to sell at the wrong time to pay for an unexpected expense. A family member of mine sold her stock investments in a panic during the financial crisis of 2008-2009. That one decision outweighed almost all others with regards to her investment performance.
One way to invest poorly is to have too thin a margin between what you’re prepared for financially and what could happen. You too could sell at a bad time, if an unexpected expense requires it. Set aside at least six months of savings. It doesn’t matter too much whether that savings is in a checking account–like my friend–certificates of deposit (CDs), U.S. treasuries, or another low-risk, easily accessible investment. We first must build a level of savings that allows us to remain calm and rational during inevitable calamities.
Calculate how much you spend each month on required expenses–home, car, food, medical. Set aside six times that amount. Keep it in a basic checking account that earns you nothing–that’s ok. Or, for a higher, low-risk return on your cash, deposit it into a high-yield savings account (today that should earn you 4-5%), buy certificates of deposit (CDs), or set up a brokerage account (I recommend Schwab.com) to buy a short-term U.S. treasury ETF such as the iShares 0-3 Month Treasury Bond ETF (SGOV).
4. Buy One or More Index Funds
With what you have left of your $100,000 after eliminating your high-interest debt and setting aside cash to cover living expenses, earn as high of an interest rate as you safely can. If you put your entire $100,000 into an investment that earns you 5% interest per year, you’ll have $265,329 after 20 years; if you put that same amount into an investment that earns you 10% per year, you’ll have $672,749. The rate of return you earn on your investments matters a lot.
If you analyze returns of major investment assets–including stocks, real estate, commodities (including gold), and bonds–going back to 1800[1], in almost every time frame of five years or more, stocks produced the highest return. Assuming you don’t need access to your investable cash and can let it grow for at least five years, invest in stocks.
Buy a low-cost index fund of the largest 500 companies in the United States. For example, the Vanguard S&P 500 ETF lets you own a portion of Amazon, Apple, Tesla, Microsoft, Procter & Gamble, and hundreds of other great companies for around $530 per share.
One key to investing successfully is to avoid high fees. Venture capital, private equity, hedge funds, and real estate all typically require paying high fees to their promoters (fund managers) to invest. These investments often require paying fees equal to 2% of the money you invest with them–regardless of whether they make or lose you money–and a high percentage of profits, such as 20%. Because of these high fees, such investments typically produce lower returns than investing in index funds. As late billionaire Charlie Munger said, “Anytime anybody offers you anything with a big commission and a 200-page prospectus, don’t buy it.” Further, they lock your money up for months or possibly years, reducing your financial flexibility. Some of these investments can produce outsized returns–the problem is analyzing which ones are likely to outperform. Most of us can’t predict that or aren’t willing to do the analysis–much like analyzing lots of stocks–to try to figure it out. So, we’re likely to produce the highest returns investing in index funds with low fees (often 1% of the cost of a high-fee alternative investment).
To reduce the risk that you invest your money before a market crash, spread out your index fund investment over three to five years. For example, divide the amount you have to invest by 48 and invest that amount each month. You’ll spread your investments over four years. You’ll be unlikely to invest all your cash at the worst possible time.
Summary
To conclude, here’s what I’d recommend a friend or family member do with $100,000 available to invest today:
- Pay off your credit cards
- Cut up and cancel credit cards
- Set aside enough to cover six months of living expenses
- Divide what’s left by 48 and invest that amount each month in a S&P 500 index fund
This is not original advice. Yet, it’s not universally followed, which is why I share it with you. Every 10 years or so, avaricious individuals will attempt to convince others ignorant of financial history that money can be easily acquired or grown through new mechanisms of investment. Soon, the hopeful investors will realize the falsity of the promoters’ claims–and suffer real, permanent financial damage. My hope is that you avoid some of the suffering caused by such people and poor investments. Avoid debt, spend less than you earn, prepare financially for the unexpected, and invest in great companies. Over time, you’re likely to do quite well.
Arguments Against Investing in a S&P 500 Index Fund
Many people dispute buying a single index fund of the largest 500 U.S. companies–often, those people have something to sell you. I offer here as supplementary reading common arguments against such an investment approach and my reasons for still recommending it.
A S&P 500 index fund is too concentrated in the United States. Over the last 10 years, an index fund of the largest 500 U.S. companies weighted in proportion to their market value returned approximately 241%; over the same period, a similar international fund returned only 64%. U.S. companies’ stocks have done extraordinarily well recently–usually this is a sign of underperformance in the future (trees don’t grow to the sky). Over the next 10 years, U.S. stocks are unlikely to do as well as they’ve done in the past 10 years; the question, however, is whether international stocks will do better. First, even if there is an economic slowdown in the U.S., most large U.S. companies produce significant portions of their sales outside the U.S. As I’m writing this, Apple is the largest company by market capitalization in the S&P 500 index fund–65% of Apple’s sales come from outside the U.S. Microsoft is the third largest company in the S&P 500 index–almost half of its sales come from outside the U.S. Second, the U.S. is home to many of the greatest businesses in the world, including 6 out of the top 10 most profitable companies. Investors are currently paying a high premium to invest in U.S. stocks, yet the American economy produces great businesses (over a long time period, the returns of your investments will equal the returns of the businesses you invest in). Spreading one’s index fund investments into multiple funds with some international exposure is not imprudent, yet it might not produce better returns than investing only in a S&P 500 index fund, assuming you spread such an investment out over multiple years.
The largest U.S. companies make up too much of the S&P 500 index. The S&P 500 is market capitalization weighted, meaning that the largest companies by market value are overrepresented in the index. Were all companies equally weighted, each company would represent 0.2% (100% / 500 companies). Because the index is weighted by company market value, Apple, the largest company in the index, represents 7.25%. The 10 largest companies represent around 35% of the index today; 10 years ago, the largest 10 companies represented only around 19%. This concerns many investors–a significant decline in the stock prices of a few of the largest 10 companies will have a disproportionate impact on the value of the S&P 500 index. Over the last 10 years, a fund of 2,000 smaller companies–the iShares Russell 2000 ETF–returned an average of 7.88% per year; over the same period, the iShares S&P 500 Index Fund returned 12.99% per year. Over a long period of time, an extra 5% per year is huge. Generally, a period of overperformance by larger companies is more likely to be followed by a period of underperformance relative to smaller companies. However, some of those smaller companies will become larger, taking their spots in the S&P 500 index. We also don’t know when the smaller companies will outperform the larger companies. Devoting a portion of one’s investments to an index fund of smaller companies is not a bad idea, but is not guaranteed to produce greater returns–it is guaranteed to add complexity.
You don’t control–and can’t touch and feel–stocks. This is a final catch-all objection to investing in stocks versus other assets. My favorite Warren Buffett quote is the following: “Owning a non-controlling portion of a wonderful business is more profitable, more enjoyable and FAR less work than struggling with 100% of a marginal enterprise.” Yes, you can buy real estate you control; yes, you can start a business you control; yes, you can buy gold and put it away in a safe that only you have access to. However, the best asset to own over the last 100 years has been–and will likely continue to be–ownership in great companies, regardless of whether you control them or not. As a shareholder, you own a legal right to a portion of the earnings of the companies you invest in. Collectively, shareholders can force change within companies they believe aren’t serving them. Full control of a company might make ownership of stock more valuable, all else held equal; however, the advantage gained through increased control is unlikely to outweigh the disadvantages of owning poor quality businesses. You’re not going to get control of Amazon, but you can prosper as it grows.
Footnotes