Thirty years ago, Dr. Lee Goldman wrote an article titled “Ten Commandments for Effective Consultation”. I’ve taken some liberties with his recommendations in the context of practice in an era...
This post is about what I would want my children to know about investing in their first few years out of college. But it applies to anyone starting their career, including physicians. This is the time of year that a lot of our trainees are finishing up and ready to go out into the workplace. New doctors are like most people who are starting a career after finishing their education – they are changing from living off of borrowed money to now having an income stream and being able to save money.
No one prepares you for how to do this, however. So, when you are just starting with your new job, be prepared to get lots of financial advice – and be warned, most of it is going to be bad. All of this bad advice can come from a lot of different directions:
- Financial advisors. Whenever you finish school, your mailbox magically becomes full of cards and letters from financial advisors. They will check college graduation lists and network with people in order to get lists of potential clients who are completing training. You will get invited to free dinners to educate you about financial planning. You’ll get phone calls and emails from financial advisors all eager to serve your financial planning needs. Beware of them – some are very legitimate professionals who can help you invest wisely and protect your assets. But others are primarily interested in making money off of your money. They are like lampreys who parasitically attach themselves to your investment portfolio and slowly suck away at your assets. Some financial advisors will charge you by the hour for advice and consultation and then leave the investing up to you – more often than not you can trust them since they make a living by selling advice – those that give the best advice get the most clients. But other financial advisors will offer to invest your money for you – I am more skeptical about them because they make a living from the commissions they earn every time they make an investment transaction. This means that they will often steer you towards investments that they can make a hefty commission on rather than things like an index stock mutual fund that has minimal or no commission with it. Furthermore, every time you sell one investment and buy a different investment, they make an additional commission so you can be left wondering, “Is this really a good time for me to buy and sell this stock or does my advisor just need to make a mortgage payment on his vacation home this month?” Other financial advisors will charge you an annual percentage of your total portfolio’s value – in theory, the more your investment appreciates, the more the financial advisor makes; but in reality, they make money off of your portfolio even in years that you are losing money, just not quite as much. Beware of them – they will be charming and persuasive but they are ultimately salesmen and what they are selling is themself.
- Friends. Be prepared for one of your friends or neighbors to say something like “I just heard about this great new company and my advisor told me to buy $5,000 worth of shares…” Everybody is going to have a hot investment tip for you. Most of them are well meaning – they think they are doing you a favor and helping you out. But often, they are also trying to rationalize the last investment decision that they made.
- Family. Family members can be just as well meaning but give you just as bad of advice. Often, they will look back to some successful investment that they made 10 or 20 years ago and recommend that you invest in it since it made money for them. The problem is that the company that was so successful 20 years ago is not necessarily going to be just as successful in the future.
- Yourself. You can be your worst enemy when it comes to investment. Do not treat investment as you would gambling. Going to the casino is something you do for recreation with the knowledge that statistically, you are going to lose more money than you make in the long run – you go to the casino to spend a little money and have fun. Investment is something that you do to secure your future – with the knowledge that you are going to make more than you lose in the long run. If you approach investment by betting on a hot stock tip or buying into a “blue sky” real estate venture, then you are not really investing, you are gambling – and in the long run, you are more likely to lose money than to make money.
So, lets start with some basics about investing with some definitions of the things you can invest in:
- Stocks. When you buy a stock, you are buying part ownership in a company. If a company does well, then the value of that company goes up and therefore the price of its stock goes up. But if that company fails, then the price of its stock falls. As a general rule, larger companies are less likely to fail and smaller companies are more likely to fail. However, smaller companies are also more likely to undergo exponential growth than large companies – think of McDonald’s or Apple when they were in their infancy. Different stock indices contain different sizes of companies – the Dow Jones Industrial Index is a small group of very large corporations, the S&P 500 is a larger group of the biggest 500 corporations in the U.S., the Russell 2,000 is a larger group of 2,000 corporations, and the NASDAQ is a group of small companies. You make money from stocks in two ways: (1) by selling the stock when it is more valuable than it was when you bought it and (2) by getting “dividends” which is money paid to the stock owners periodically when the company is profitable (some companies will put profits back into the company to open new stores, or build new factories and other companies will give profits back to the company owners, i.e., the stock owners).
- Bonds. A bond is a loan to a company so when you buy a bond, you are loaning the company money for some defined amount of time. Not only do companies borrow money with bonds, but governments do, also. Maybe a city needs a new high school building so they sell municipal bonds. Or maybe the U.S. government needs money so they sell U.S. Treasury Bonds. Just like your car loan has interest on it, the bond will also have interest on it. But if the company goes under, the bond owner may not get paid back. As a general rule, the riskier the company is, the higher the interest rate they will pay on their bonds. The U.S. government is seen as a pretty financially solid institution so the interest on U.S. Treasury Bonds is pretty low. On the other hand, a new start up company is a much riskier venture so the interest on their bonds will be high. “Junk bonds” refer to those very high-risk bonds that pay a lot of interest but have a significant chance of going out of business. A bond that is set at 5% will pay the bond owner 5% of the total amount of the bond per year for the duration of the bond, exactly like you pay annual interest on your car loan to the bank that you took out the loan with. Bonds can also be bought and sold (“traded”). Depending on factors like the inflation rate and the company’s financial status, the price of that bond may go above or below the original amount that it was sold for. So, for example, a bond that was originally purchased for $100 at 5% annual interest in a company starts to lose money and looks like it might go out of business might now sell for $90. On the other hand, if that company starts growing and looking more profitable, that bond may then sell for $102.
- Mutual funds. Buying stock in one or two single companies is risky – you might make a huge profit if they do well but you can lose a lot of money if they do poorly. A product that is enormously popular today may not be popular at all in a couple of years. Similarly, the new CEO or new Board of Trustees of a successful company may make phenomenally bad business decisions in the future, resulting in the company failing. Therefore, buying individual stock in a company is pretty risky and can cross the line from investment and into gambling. Just like you wouldn’t go to the casino to try to grow your entire retirement account, you shouldn’t put your entire retirement account in a small number of individual stocks. The more different stocks you own, the more you become diversified with the result that if a few companies do poorly and lose money, then statistically, a few others will do well and make money. The more diversified you get, the more likely you are to make money in the long run than you are to lose money in the long run. And that is where mutual funds come in. When you buy a mutual fund, you are buying small amounts of stock in lots of different companies that are all bundled together in the mutual fund. Some mutual funds are made up entirely of a group of stocks and others are made up entirely of a group of bonds and still others are made up of a combination of a group of stocks and of bonds. Mutual funds can be grouped into 2 broad varieties: (1) managed mutual funds and (2) index mutual funds. A managed fund will have a fund advisor or group of advisors who select the various stocks and bonds to buy for the mutual fund. An index fund is composed of a portion of all of the stocks in a particular category – for example, the S&P 500 – a computer adjusts the amount of each stock held by the fund based on its value or number of shares. Occasionally, there will be an investment genius who always pick the right stock (think Warren Buffett) but most managed fund advisors actually do worse than index funds. Moreover, managed funds are expensive since you have to pay pretty high salaries to the fund managers out of the profits of the mutual fund whereas index funds tend to be cheap since you don’t have to pay a fund manager – instead, an inexpensive computer does all of the buying and selling of stocks within the mutual fund based on which companies are in that particular category that month (for example, the S&P 500).
- Savings accounts. This is money that you loan to a bank so that the back can then loan money out to other people. Because the bank has to pay its bills, it will always set the interest it pays you in your savings account a lot lower than the interest rate on the loans that it makes to other people (for mortgages, car loans, etc.). However, savings accounts are very secure and are insured by the federal government so that even if the bank goes under, you can still get your money back from the savings account. Savings accounts pay the lowest interest of all common investments but have the advantage that you can open the account with a very small initial deposit and that you can take money out anytime you want.
- Certificates of deposit. These are sold by banks and are a lot like a savings account but unlike a savings account, when you put your money in a CD, you agree to not take it out for some defined period of time, for example, a 6-month CD or a 3-year CD. Because the bank knows that it doesn’t have to worry about paying you back for this defined amount of time, it will pay you a higher interest rate than it would for a regular savings account.
- Money market accounts. These are held by banks or investment companies and are somewhere in between a savings account and a mutual fund. The money market fund will have some investments (generally things like CDs and bonds) and will pay you interest – that interest may go up or down depending on how the investments are doing. You can take your money out of the money market account anytime you want to and the interest paid by the money market account can go up or down. One key difference between the money market account and a savings account is that money market accounts will generally have a relatively high minimal deposit amount. Because of this, money market accounts pay you a little higher interest than a savings account.
Ranked from lowest risk to highest risk:
- Savings accounts
- Certificates of deposit
- Money market accounts
- Mutual funds
But the riskier the investment, the more you can potentially make from it, particularly if you hold that investment for many years. Ranked from lowest potential profit to highest potential profit:
- Savings accounts
- Certificates of deposit
- Money market accounts
- Mutual funds
As you can see, risk and potential reward go hand-in-hand. So, if you are just starting out your career and you finally have some extra money that you can put into savings or into retirement, how do you know what to do? Here are 15 guiding principles to begin investing with:
- Have an emergency fund. This is money that you can get to on short notice in case you have sudden unexpected expenses or lose your job. Some people will recommend that you have 3 months’ worth of expenses in your emergency fund, other people will recommend 6 months (for expenses, think what you pay each month for rent, food, bills, car insurance, loan payments, etc.). I don’t think that one number fits all people. If the job market is poor, you may need 6 months’ expenses in your emergency fund to get you through until you can get a new job and relocate. But if the job market is great and you are in a high-demand field where you know you can get a new job right away if you need to, maybe you only need 3 months’ expenses. Your emergency fund should be in a savings account or in a money market account that you can get to on short notice.
- Don’t rack up excessive debt. When you invest, you are making money; when you have debt, you are losing money. Always, always, always pay your credit card balance at the end of each month. And don’t take out a car loan to buy a Lexus when you are earning a used car salary. Some debt is necessary, such as student loan debt. Some debt is acceptable, such as a mortgage on your home. But some debt is frivolous and unwise, like extending your credit card balance so that you can buy a new set of golf clubs. But failing to pay off your credit card balance or taking out a loan for something that is not absolutely essential will result in you paying interest charges that will wipe out any gains that you make on your investments. Think of loans and debt as “anti-investments”.
- Don’t pay a person to invest your money. Investing is scary and it can be tempting to hire a financial advisor to invest your money for you because you’re afraid you are going to make a bad decision if left on your own. Financial advisors are expensive and they are not always terribly wise. Once you become a millionaire and need to do selective investment for tax-savings purposes or a wealthy politician and need to have someone direct your investments to protect you from conflicts of interest, then you can hire a financial advisor. But in the first few years of your career, I don’t think you need one. Don’t be lured in if a financial advisor wears really nice suits or has a really magnificent office – remember that it was the money that you and people like you pay them that allows them to have a beautiful office and a personally tailored suit. In your first few years of your career, you should do your own investing, just do it simply and intelligently. Your first investment should not be an investment of money but instead should be an investment of time in learning about the basics of investing so that you can do it yourself.
- Don’t buy individual stocks. If you want to buy individual stocks, wait until you are wealthy and can either buy stocks in a whole lot of different companies to create diversification or wait until you are wealthy and can afford to buy individual stock as a means for your own recreation and amusement. But for the new investor, individual stocks are too risky.
- Do buy mutual funds. I believe that diversification is always the right thing to do but when you are a new investor, diversification is the only thing to do. The simplest way to diversify is to buy into a mutual fund. That way, you spread out your investment over dozens or even hundreds of different companies’ stocks or bonds.
- Know your investment horizon. The sooner you think you will need your invested money, the lower risk you should take with that money. So, if you are saving up for a European vacation a year from now, go with a money market. If you are savings up to put a down payment on a new house 4 years from now, go with a bond mutual fund. If you are saving up for retirement 35 years from now, go with a stock mutual fund. The sooner you will need the money, the lower the risk you should take with your investment and the further in the future that you will need the money, the greater the risk that you should take with your investment.
- Your first mutual fund should be an index fund. I’ve already mentioned that index funds on average out-perform managed funds. This may seem counterintuitive but the fund managers are human and humans are fallible and an exceedingly small number of fund managers are actually smarter than the stock market. Picking winner stocks is a little like picking winning horses at the races – there is a little bit of science but a whole lot of luck and just because a particular fund manager did a great job of picking stocks last year does not mean that he/she will do an equally great job next year. Even if you find a fund manager that is omnipotent and consistently picks winners, that managed fund will be more expensive in terms of annual fees than the index fund. Look for an index fund that (1) gives you a broad exposure to a lot of companies, (2) has no “front load” (an initial charge to invest your money – usually some percentage of the total amount that you are depositing), and (3) a very low annual fee. Still don’t know what to do? Then start with the Vanguard U.S. Total Stock Market Index Fund and then compare the stock composition and annual maintenance fees of index funds offered by other investment firms to it as you are deciding on which fund to buy. Purchasing your first mutual fund is pretty easy – you can get on-line with a large investment firm (such as T. Rowe Price, Vanguard, or Fidelity) and set up an account while sitting at home on your couch.
- Dollar cost averaging is smarter than you are. Dollar cost averaging is the strategy of investing a set amount at regular intervals, for example, $100 every month. On months that the stock market is down, that $100 will buy you more shares of that particular mutual fund and on months that the stock market is up, that $100 will buy fewer shares. Many investors try to “time the market” and only buy shares of stocks or mutual funds when they think the prices are at rock bottom and are set to go up and then those same investors will sell their shares of stock or mutual funds when they think the prices are as high as they are going to go and will soon be falling. The problem is that almost nobody is smarter than the market and the stock market is just as apt to go down in the next few months as it is to go up in the next few months. Your best strategy, particularly for long-term investments such as retirement and children’s college funds, is to set up a monthly direct deposit from your checking account into your investment fund. If you think you’ll be able to afford to save $1,200 a year, then set up your direct deposit for $100/month.
- Don’t follow the herd. Everyone knows that the secret to successful investing is to “buy low and sell high”. That sounds great but it is completely contradictory to human nature. Our tendency is to do what everyone else is doing and if everyone is panicking and selling their shares in a falling market, our reflexive action is to also panic and sell, even when by doing so, we sell when the stock market is at a low rather than a high. For generations, stock markets go down and then they eventually go up and over time, they always go up. If you are investing for a long horizon, then news that the Dow Jones Industrial Index fell 2% today should be of no greater significance than the fact that it rained today. I do have a personal flaw, however – whenever the stock market is in a “correction” and has a lot of days/weeks of sustained losses and whenever our country finds itself in a recession, I buy more shares of stock mutual funds. I just can’t help myself. I know that no matter how dismal the financial news is and how bad the economic forecast is, stocks are eventually going to go back up. In this sense, I am being a contrarian, rather than following the investor herd.
- Buy it and then forget about it. Well, sort of… The more often you buy and sell, the more often you generate sales fees to brokers who facilitate those sales and purchases. Over time, those sales fees erode your net investment value. Think of investments like you would a tomato plant – put it in the ground once and let it grow and you’ll likely get lots of tomatoes later in the summer. But if you keep digging it up and replanting it trying to get in just the right amount of sun and better soil composition, then you’ll find that at the end of the summer, you don’t have as many tomatoes. That having been said, it is a good idea to look over your various investments about once a year to be sure that you have the right investment risk mix for your investment horizon. Just remember, investment is all about maximizing your proceeds long-term, not short-term. If you keep track of your investment fund value daily, you will go insane – instead, track it quarterly or annually.
- If you don’t understand it, don’t invest in it. A perfect current example of this is bitcoin. 90% of Americans have no idea what a bitcoin is or how bitcoin works but most Americans have heard about how bitcoin has increased in value exponentially over the past few years and suddenly, everyone wants to invest in bitcoin. This is like lemmings blindly running towards a cliff. The same thing happened 10 years ago with investors purchasing bundled mortgages.
- Buy insurance judiciously. Everyone needs health insurance (I mean, come on… I’m a physician!) and everyone should have disability insurance (if they can get it). Life insurance is a bit more optional. If you are single and don’t have any children, you probably don’t need any life insurance. If you have a spouse and/or children, then life insurance becomes more of a necessity. But buy a term life insurance policy, not a whole-life policy. Also, avoid annuities – they can be very complicated to fully understand and they are almost always way too expensive in terms of up-front costs and/or annual maintenance fees.
- Planning for retirement means not being that old guy in the little office at the end of the hall. Every company has this guy. He is the fellow who is 5 years older than the age that everyone else retired at. He is bitter at the world, laments for the “old days” and doesn’t really like what he is doing. He is in an office out of everyone else’s way and doing some menial task that no one else wants to do. The company keeps him on the payroll out of a sense of loyalty to him. He’s the guy who never saved enough for retirement. Once you have a paying job, you are never to too young to start saving for retirement and no amount is too small to save. Even if you can only save $500 this year for retirement, if you put it in a broad stock market index fund, then based on historical rates of return, in 35 years, that $500 will be $16,000.
- Choose retirement investment options strategically. In a previous post, I outlined my recommendations for physicians saving for retirement but these recommendations can really apply to anyone. For the background on why I recommend this approach, read that previous post. But to summarize, here is the priority for selecting among different retirement accounts (not all of these plans will be available to everyone):
- Employer-matched 401(k)
- Non-matched 401(k) or 403(b)
- Simplified employee pension plan (SEP)
- Roth IRA
- Regular investments
- Traditional IRA
- When starting out, use an incremental investment strategy. Lets say you are a few months into your first paying job and you decide that you can save $100 a month. You would like to put that money into an index mutual fund but the minimum amount that it takes to open the fund is $2,000. And the minimum amount that it takes to open a money market fund is $1,000. No problem – start by putting $100 per month in a savings account and then when you have enough to open a money market account, transfer it there. Then when you have enough in the money market account to open the mutual fund, transfer the money there. Whatever you do, don’t abandon all hope because you think that the amount you can afford to put away each month is too small to make investing worthwhile.
I have had at least one friend or colleague who has made a mistake with at least one of each of these 15 guiding principles and then later regretted it. Investing means creating the freedom of your future. It is not difficult but it requires a little bit of planning and a lot of patience.
April 20, 2018