Managing Money = Saving Money = Extra Money for Investment
I want to start this blog by talking about the analogy of fitness and financial management in dental school. We are all going to be dentists one day, and I believe most of us envision of having a comfortable lifestyle where we will be able to spend money on vacations and things we have always desired, or we will be able to help out charities and contribute to various noble causes. Just like trying to maintain a healthy body shape by keeping a daily caloric deficit and working out several times a week, spending less than we make and forming the habit of wisely investing the difference is one of the surest ways to build wealth over a lifetime.
Here are several things we can start doing as dental students to keep that already hefty hole of student loan debt as shallow as possible. First and foremost would be to condition our brain into a saving mode instead of a spending mode. I’m a firm believer in the saying that “wanting leads to suffering.” If we could alter our perspective to be satisfied with what we already have, rather than giving in to our temptations to spend, we could be saving a lot of money. The most straightforward way of saving money is to write down everything we spend in a given month. By writing down the expenses, two things would occur. We get an idea of how much we spend in a month, providing an idea of how much we can invest. It also makes us more accountable for our spending, which encourages most of us to cut back. Lastly, we want to pay off all of our current small debts on time: credit card debt, utility bills and so on, as they tend to accumulate penalties for late payments and dampen our credit score.
Our Most Valuable Gift: Time!
Before talking about the types of investment, I want to point out one very valuable gift that we already have—time! I will explain why time is precious and powerful with the concept of compound interest. Let’s assume we start with investing $100 in the first year that attracts 10% of interest in one year. It will give us a $10 gain. We would start the second year with $110, and assuming the interest rate stays at 10%, we would end up with an $11 gain in year two, turning $110 into $121. As the snowball rolls on, we would eventually grow a substantial amount of wealth. To drive this point home, this count below shows how much money we would end up with if we invest $100 at age 0 (original investment) and let it gain compounding interest for 100 years, assuming the interest made each year is 10%.
5 years = $161
10 years = $259
20 years = $673
30 years = $1,745
40 years = $4,526
50 years = $11,739
70 years = $78,975
80 years = $204,841
100 years = $1,378,061
Of course, no one would only invest $100 for their lifetime and rarely anyone would need to wait for 100 years until they can reap the rewards of investing. But the key is to show how powerful compounding interest is and how crucial it is to start investing as early as possible so that there is more time for our money to compound in the market. Warren Buffet started investing at age 11 by purchasing his first stock, and he jokes that he started too late. Realistically speaking for us dental students, if we start putting money in an investment fund at the age of 25 and starting to cash out our investment at age 65, we would have at least 40 years for the money to compound! Plus, compounding does not stop once we retire, since we only cash out a small percentage each year along the way, and we can choose to let our investment compound for as long as we live.
Passive vs. Active Investment
So what kind of investment should we put our hard-saved money into in order to generate a steady, predictable, and long-term return with no major hiccups?
Let’s start with the most common notion we have when we hear the word “investment”. It usually means that we put our money and time into an asset or item that we speculate that would increase in value over time, and we can profit from that increased value. For example, when I first hear the word investment, I think about cherry picking a few famous stocks such as Apple, Google, and Coca-Cola, and hoping that I will have the market acuity to sell them at the highest possible point and make a huge profit.
What I just described is a prime example of active investment, a speculating game that no one knows how to play and no one ever will—because there are no rules and zero patterns. The above scenario would be a dream for everyone, but so is winning the lottery—the chances are incredibly slim. And yet, there are thousands of professional financial advisers on Wall Street and elsewhere who claim that they know the ins and outs of the unpredictable nature of the stock market. Here is how the textbook actively managed mutual fund (aka active investment) works: the adviser (aka broker) would take our money and send it to a fund company, which combines our money with other active investors’ money into an active mutual fund. The fund company has a fund manager who buys and sells certain stocks within that fund, praying that this active buying/selling will generate a profit for investors. So what’s the problem with active investing and buying stocks directly?
In order to understand why active investing is perhaps not your best option, you must first be introduced to the single most important concept in the investment world—the index fund! Index funds are also known as passive investments, due to their nature of non-speculating and low trading frequency. Just as a book’s index is used to represent the entire content of the book, index funds are representations of the entire US stock market that contains thousands of stocks within it. Thus, instead of spending $100 to invest in one single stock of Apple or Microsoft, we spread this $100 to every single stock that is out there no matter how little of each share we own. By doing this, we essentially diversify our money into the entire stock market. But why would we do that? Why would we bother to invest in index funds when the market is still unpredictable anyways? The key word here is again—time! Based on data from Morningstar.com , the US stock market has generated annual returns of more than 9% for over 90 years, and this included some famous stock market crashes during 1929, 1987, and 2008. Therefore, in the long run, the stock market has always been trending upward, despite a few ups and downturns over the years. Similarly, other economically dominant countries’ stock market, such as UK and Germany, have also mirrored a similar 9% increase in the long run. More importantly, by reinvesting the index fund dividend each year back into our account, we are essentially building a compound interest snowball that will grow and grow until the day we retire. Thus, the wisest investment decision would be prioritizing index fund investments for a LONG period of time and diversify our investments into both domestic and international stock markets. Also, start early!
Now that we know the concepts of both active investment (speculating) and passive investment (index fund and bond), I would like to point out why active investment is inferior to passively investing in index funds over the span of a lifetime. The seemingly strategic buying and selling by an active fund manager is in fact a losing battle when it is compared with index funds over the long term. To understand why, let’s assume in 2016 the US stock market moved up by 10%, which means the average dollar invested in the stock market has increased by 10%. The key word here is AVERAGE. When the market moves up by 10%, some investors made more than 10%, and some made less than 10%. The average of all the gains and losses would be 10%. So what are the odds for an active investment broker to make more than the market average return of 10% and beat the index fund?
The answer would be 50-50 IF our Wall Street brokers worked for us for free and the mutual fund company didn’t cost anything to operate. Of course, this is impossible. When we look at a 15 year-long study conducted by the Journal of Portfolio Management , 96% of the actively managed mutual funds underperformed the US market index fund after all the fees (expense ratios, 12B1 fees, trading costs, sales commissions, and taxes) that we would pay to our mutual fund managers/advisers. Taxation occurs whenever a profit is generated from that fund. Since actively managed mutual funds are all about constant trading (selling), each sale generates a tax bill for the investor, and thus substantially lowers the return once you add up all the fees and expenses.
Index funds, on the other hand, are an investment in the entire stock market. The return of the index fund will be extremely close to the average market return of that year with little surprises. If there were a 10% increase in the stock market in a given year, the return of the index fund would be 9.7% or 9.8%. It is never higher than the average market return, but it guarantees all index fund investors the same amount of return without discrepancies. In addition, index funds are rarely traded or sold until the day that we decided to cash out, and that day is not until we retire. Since there is no trading, there is no taxation of the investors. Therefore, in addition to a much steadier and more predictable long-term gain, index funds have another edge over actively managed mutual funds—tax efficiency and low or no extra fees.
The Best Way to Build an Investment Nest Egg While in Dental School
So far I have covered what index funds are and why actively managed mutual funds are a trap for our hard-earned money. Now, let’s talk about the how-to part—how we can start our own investment account as a dental student when most of us have no background knowledge in investing (and when we are spending the bulk of our time studying for teeth). What if there was a company that could help us manage an index fund account and do it for a fee that is almost 60% lower than the average fund fee? What if all we needed to do was spend one hour per year (or not even) to managing our account? It may sound like a hoax, but there is such a company out there.
Here comes Vanguard, the world’s largest provider of index funds, started by investing legend John Bogle as a nonprofit firm. Vanguard started by focusing on lowering the cost of investment by letting investors go through the DIY routes of investment. The DIY strategy includes either letting the investor pick through Vanguard’s offerings of index funds or building their own portfolio with ETFs (the cousins of index funds). As cheap and relatively easy as the DIY strategy with Vanguard is, it still lacks the guidance that new investors often feel that they need. Vanguard eventually realized this complication and now offers an even lower-maintenance, low-cost, hassle-free, already-built product that consists of entirely indexed funds and bonds. This heavenly product offers a “couch-potato” way of passive investing that fills the investors’ portfolio with safer and yet steadily growing index funds and bonds that are distributed according to investors’ age (I will explain the distribution soon).
So what is an investment portfolio? How do we build a portfolio with Vanguard? Any smart investor (aka all of us) should have an investment portfolio that includes at least two components: index bonds and index funds (stocks), both which consist of a domestic stock index component and an international stock index component. A bond is money that we lend to a first-world government or a reliable corporation. Our money is safe with the government or the corporation as long as they are able to pay the money back, plus our annual interest. Bonds are our security blankets in terms of investing because they are much less volatile than stocks, although they earn less interest. So if the stock market crashes all of the sudden, bond (not 007) is right beneath us to make sure we have a soft landing.
Now that we know what index funds and bonds are, what should be the distribution between bonds and stocks in our portfolio? The ultimate rule of thumb is that we should have a bond allocation relatively equal to our age , or our age minus 10. It all really boils down to how much risk we can take. The younger we are, the more risk we are typically willing to bear. For example, if we are 25 years old, our bond % should be 10-20%, and the index funds should be 80-90%. But, if we are 55 and close to retirement, there should be 40-50% of bonds, and 50-60% of stocks in the portfolio. Of course, the distribution is always fluid based on the market, and we have the ability to rebalance our account. The concept of rebalancing is simple. Let’s use the analogy of buying composite material for our future practices. If the composite market suddenly goes on sale, what should we do? It’s a no brainer—everyone should stock up composite in the practice while the price is low! The same rule applies to the stock and bond market. When the stock market goes down, we rebalance our account by buying more stock and less bond—the basic rule of “buy low, sell high”. Except we don’t sell the stocks in the world of index fund, we hold them until the day we are ready to retire. If rebalancing still sound too complicated to a DIYer, don’t worry, the product that Vanguard offers automatically rebalances itself once a year.
That’s it! Now let’s wrap up this blog post by talking about how I started to invest with Vanguard all by myself with absolutely zero Wall Street experience. Sounds crazy, right? But, it’s a process that is straightforward enough that every dental student will be able to do it! I opened my investment account with Vanguard right before I started dental school in 2016. I projected my retirement year to be 2055, 35 years after I graduate from dental school. All I did was to apply for a Vanguard account via mail. Once I activated my account, I went through a list of Vanguard’s Target Retirement Funds to find the “Vanguard Target Retirement 2055 Fund (VFFVX)”, which matched my projected retirement age. There are other funds with the same name except different retirement years. VFFVX 2055 contains a diversified portfolio within a single fund that adjusts its underlying asset mix over time. At the bottom of this post, you can see what the distribution of my portfolio looked like when I opened my account in 2016:
Based on my age (25) and my risk-taking ability (high ability to take risks), VFFVX 2055 assigned me 90% of stocks and 10% of bonds. We are able to change this composition if we feel uncomfortable with the % of stocks. But, since I’m only in my 20s, I will take the risk of having way more stocks than bonds so that I will maximize my reward in the long run. Of the index stocks that I own, 54% come from domestic (US stock market) and 36% come from international stock markets. I also own 7% and 3% of indexed domestic bond and indexed international bond, respectively. I set my account on an autopilot where it takes $100 per month from my bank account for investment purposes. Then I never have to worry about the account again unless I change my mind about how much money I would like to put in monthly, or the distribution of stocks and bonds. By the end of one investing year, the dividend is automatically reinvested into my portfolio based on the distribution, and the account is automatically rebalanced by Vanguard. Every couple of years, this fund and every other similar fund with different retirement years will reduce its % of stocks and increase its % of bonds as people getting older and closer to their retirement.
Finally, let’s take a look at the performance of the Vanguard Target Retirement Fund since its inception. This bar graph shows that the VFFVX 2055 retirement fund has given a 10.77% return since 2010—a return that’s considered above the historic market average of index fund performance (8-9%). Of course, the future stock market will be subject to economic crises and other factors that will affect its performance. So, the “dog leash” of the stock market will likely to come back to the average of 9% in the long run. (Source: Vanguard.com)
Nevertheless, Morningstar.com compared the track records of Vanguard’s Retirement Fund with the average active investor who hired Wall Street guys’ performances in the past 10 years, including the Great Recession in 2008. It turns out that the average investors only gained 6.37% in interest whereas investors who invested with Vanguard’s index fund gained 8%. The speculation game did nothing but add panic and indulge investor greed. By choosing to participate in irrational trading and speculative buying, they missed out on an additional 1.63% in interest. Vanguard’s investors, on the other hand, kept their cool and kept adding money to their portfolios monthly, regardless of what the market movements or hearsays were. This seemingly lazy strategy worked like a charm and safeguarded the index fund investors through the traumatic 2008 financial crisis.
 The Value Line Investment Survey— A Long-Term Perspective Chart 1920-2005 and Morning Star Performance Tracking of the S&P 500 from 2005 to 2016, www.morningstar.com
 David F. Swensen, Unconventional Success, a Fundamental Approach to Personal Investment (New York: Free Press, 2005), 217.
 Hallam, Andrew (2016-11-28). Millionaire Teacher: The Nine Rules of Wealth You Should Have Learned in School. Wiley.