Investing Doesn’t Need to be Complex

We all know that investing over time is the key to obtaining the wealth that we desire. Without investing in some form, dollars stuck under our mattress are eaten away by inflation, and we have to save at least $1 today for every $1 we want to spend in the future. By investing, we not only expect to outrun inflation, but we hope that $1 spent later costs us less than $1 saved today.

At the same time, on some level, you’ve probably realized that investing can be intimidating. I have friends who do not invest at all because they’ve become discouraged by recent returns or they believe that investing is too complex. How are you supposed to pick “the right investment”? What are you supposed to do when the market is tanking? And how should you allocate your investments?

Wall Street loves complexity because the standard investment vehicles are old and boring. Instruments like credit default swaps exist to make investing exciting for traders. But for those of us who live on Main Street, we would do best to throw all of these complex instruments out the window. If you can’t explain the type of investment to your grandma, then it’s too complex for your portfolio.

I strongly believe that the two factors that will have the largest impact on the eventual balance of your investment portfolio are:

  1. Investing more, sooner
  2. Keeping your investments simplified

I’ve already discussed the benefits of investing early (http://hackingthebank.com/investing-roth-ira-when-young) previously. The more that you can invest, and the sooner you can do so, the more you’ll end up with.  But I think that the simplification of investments is often ignored. A target date retirement fund can provide the ultimate simplification. But beyond that, I consider a “simplified investment portfolio” to be a portfolio consisting of a handful of index funds. For some great examples, check out the Bogleheads Wiki of Lazy Portfolios.

By investing in a handful of index funds with a proper asset allocation, you eliminate the risk of “picking the wrong stock.” You aren’t trying to speculate in gold or worrying about finding a tenant for your rental home. Just include a REIT in your portfolio as a real estate investment.

By keeping things simple with a handful of index funds you’ll be outperforming a majority of mutual fund managers. You also won’t have to worry at night that you’re invested in the wrong asset. For most of the year, you can relax and forget about your portfolio. Although I know a good deal about investing, I don’t watch the markets on a daily or even weekly basis, because I don’t worry about my portfolio at all. It’s simple and it’s sticking where it is. If you aren’t already investing in a handful of index funds, try it out and you will soon begin to appreciate simplicity.

Your Savings Rate Matters Most When You’re Young

Your savings rate, particularly when you’re young, has a much greater affect on your wealth accumulation than higher returns do. The reasoning for this is simple. When you’re portfolio is small, you’re (hopefully) contributing more each month than your portfolio is earning.

Let’s check out how this works with some numbers. Let’s compare two different investors. Each makes $50,000 at age 25 and their salaries increase by 3% per year until they’re 65.

Max: Saves 6% of his salary before tax, spends time finding the best investments and earns 10% per year. To earn this return he has to follow his investments more closely, and tends to stress over his investment options.

Ralph: Saves 12% of his salary before tax. This is double the savings rate of Max. However, Ralph doesn’t like to worry about his investments so he invests in an index fund that earns him an average of 6% per year. He rarely checks his portfolio balance and doesn’t stress about fluctuations in his balance. He doesn’t waste a lot of time following the market.

As you can see, Ralph is saving a higher percent of his income, but Max is earning a higher rate of return by spending time carefully choosing winning investments. Below is how their wealth would accumulate.

Savings Rate Matters More Than Earnings Rate

It takes nearly 30 years for Max to catch up to Ralph.
(Click on graph for a larger view)

Max doesn’t catch up to Ralph’s wealth until he’s 54. This illustrates the heavy impact that a savings rate has on wealth accumulation. If you’re saving more, you have plenty of time to find that investment strategy that is going to yield a higher return. If you’re not saving enough, even a great investment strategy won’t help you catch up.