I wrote this for my brother. Money decisions are intensely personal, and if you aren't my brother and you don't agree with what I've written here, note that your financial situation is likely different and you should do different things accordingly.
When you’re not in school anymore, at some point you will get a job and start making money. Good for you! You’re employed!
Once you’re employed, your first goal should be making sure you’re spending, on average, less than you make. The unit of time doesn’t really matter, but since so much of the world works on a monthly cadence (bills, rent, Netflix subscriptions, etc.), my thought process centers around spending less each month than I make in an average month. When you spend less than you make, then congratulations! You can start saving!
Note: It takes some people a lot of time just to get to the employed + saving part, and that's ignoring very common issues like debt. I don't mean to imply that getting to this point is necessarily easy, just that much of the advice I'm going to give explains what you should do once you get there. If you have debt, you'll want to employ a different strategy.
Generally you start out with a single bank account, usually a Checking Account or a Savings Account at some bank. Once you’re making a profit every month, you’ll see the numbers in those accounts go up at a regular cadence, and you’ll find that you’re storing a sizable chunk of cash in that account. Unfortunately, a checking or savings account is generally a bad place to store sizable chunks of cash. To understand why, we have to explore the spectrum of liquidity and yield.
Liquidity is, roughly speaking, the ease with which something turns into cash. Cash is the Most Liquid Thing because cash very easily turns into cash. Money in your savings account is very liquid because it too very easily turns into cash at an ATM. A bond is not very liquid. When you buy a bond, you give the government money and they promise to give you more money after a certain amount of time, like two years. When the government has your money, it’s very difficult to turn into cash: the government won’t give you the money back until the two years is up. But they give you more money, which is sort of like a thank-you for letting them borrow your money for two years. Comparing a bond to money in your savings account is a good example of a general investing rule:
The more liquid an asset is, the lower yield you’ll be able to get from it.
When your money is in a savings account, you get a 0.03% APY (Annual Percentage Yield): your money will grow 0.03% year over year. That is shockingly little, but you can access it immediately, whenever you want. If you put your money into a CD (a Certificate of Deposit, which is kind of like a bond), you get a 2.15% APY, but you don’t see that money again until two years later. If you buy a house, you can get a very large return on investment, but in order to turn your house into cash, you have to sell the house, which is a chore.
Real estate complicates the General Investing Rule by introducing the concept of risk. You don’t always get the same return on investment when you buy a house because buying a house is very risky: land value rises and falls drastically and (in some senses) arbitrarily. On the other hand, putting your money in a bond is not risky: once the bond’s time is up, you’ll get your original money + the APY unless the government has gone bust, at which point you’ll have bigger problems. This introduces the second general investing rule:
The riskier it is to put your money somewhere, the more reward you have the potential of getting, but the higher the likelihood is that you’ll lose it all.
In 2019, annual inflation was 2.29%. $100 on December 31, 2019 is worth 2.29% less than that same $100 was worth on January 1, 2019. Careful readers might notice that that inflation rate is more than the APY of the CD listed above, and is much more than the APY of the savings account. This means that if you put all your money in a savings account or a CD, that money is slowly losing its value each year. Bummer! In order to ensure that your money isn’t slowly losing value, you want to invest in things that have a higher APY than inflation: generally, people shoot for at least a 3% APY for their investments. Based on the two rules of investing, you can deduce that there are two ways to get a high APY: either invest in very non-liquid things, or invest in high-risk things. You could get a 10-year CD and get an APY of 2.3% (still low-risk but incredibly low-liquidity), but instead we’re going to talk about investing in the stock market, which introduces some risk but means you can very easily get over the inflation hump and start having your money make money.
Your first entry point into the stock market should be through tax-advantaged brokerage accounts, which is a fancy way of saying retirement accounts (so you get taxed less) that other people manage (so you don’t stress out about stocks). Why do you get taxed less when you put your money in retirement accounts? The American government wants you to be set to retire. They want to make sure you’re putting enough money away so that when you do retire, you’re not using too many public resources to fund your retirement. To get you to save your own money for retirement they give you incentives, which come in the form of lower taxes.
Generally, when you make money, you have to give the government some of it. That’s regardless of how you make that money, so when you get a paycheck you pay taxes on that, and if you use some of your paycheck to buy some shares of a company and you make money, you also pay taxes on that. For those of you keeping score at home, that means you get taxed twice, once for each income event. The government has set up two types of investment buckets where, if you play by the rules and don’t take money out until you retire, you only get taxed once. Those two buckets are:
- a Roth IRA, in which you pay taxes on income but don’t pay taxes on investment profits, and
- a 401k, in which you (typically, but not always) pay taxes on investment profits but not on the portion of your income that goes into it.
You're only allowed to have one of each, and they both come with federal contribution limits. As of 2020, you're only allowed to put $6,000/year in a Roth IRA, for example, and you're not allowed to contribute to a Roth IRA at all if you make more than $135,000 annually. The rules are more complex than that, and a 401k has other rules.
I called both of them “buckets” because they’re not types of investments themselves; rather, they hold the various investments you can have. Having a 401k doesn’t mean you’ve invested money in any particular thing. You could buy two thousand shares of Snapchat (really Snap Inc.) and have that be your entire 401k if you were crazy. Generally, though, you don’t want to be the one picking which companies you invest in. Instead, you want to pay smart finance people money to pick the stocks, because they’re going to be better than you at picking them.
The smart finance people have set up index funds, which are big slurries of different stocks that the finance people manage while skimming a small amount of profits off the top. There are tons of different index funds: there are some that invest equally in each of the top 500 American companies. There are some that invest in specialized markets, like foreign shipping companies. There are some that dynamically switch from stocks to bonds over time, such that the fund is a high risk and high reward one today, but in 2065 will be low risk and low reward (which is generally how you want to manage a retirement portfolio). The index funds you invest in are kind of a personal choice, though that choice mostly depends on your willingness to take on risk.
What You Should Do
You should create a Personal Investor account with Vanguard, which is a company that does two things: they offer different types of brokerage accounts (the 401k and the Roth IRA are examples of types of brokerage accounts), and they manage a suite of index funds. Vanguard is a trustworthy company that people really like; it also makes your life simple to choose them because you can go to one website and manage all your investments there.
By convention, people generally set up a Roth IRA on their own, and let their employer set up a 401k for them. Once you’ve created your account with Vanguard, you should open a Roth IRA with them. Over the course of the year, you should transfer money into your Roth IRA; you don’t want to transfer it all and buy all your index funds at once, because you don’t know if this is a particularly expensive time for the stock market; instead, you want to contribute and invest a bit, regularly, throughout the year.
As you transfer money into that account, you’ll be able to invest that money in different index funds. I’ve invested in index funds like:
- VOO, a set of stocks in the S&P 500 index. VOO has effectively had an 11.66% APY over the past 5 years.
- VLXVX, a fund that adjusts its stocks over time with a target retirement date of 2065. It is a very new fund but effectively had a 24% APY over the past 1 year.
- VTWAX, which is some fancy global fund with a low expense ratio: they skim relatively little off the top. This fund is also new, and has had an effective 17.54% APY over the past year.
At roughly the same time you’re setting up a Roth IRA, you’ll want to set up an emergency fund. You want an emergency fund to be high liquidity (so you can get to the cash easily) and low risk (so you don’t wake up in an emergency to find it gone), which will mean that it has a low APY, even below inflation. People tend to think of this as a price they’re paying to have access to their emergency fund. You want your emergency fund to hold roughly 3-6 months of expenses. You can also fill this up gradually, similarly to how you contribute to your Roth IRA over the course of the year. I have my emergency fund at Ally Bank, which is an internet-only bank which offers a savings account with a roughly 1.7% APY (it fluctuates, but has historically lived around there). Internet banks have some tradeoffs (I can only withdraw money 6 times per year without incurring fees), but the increased yield is worth it; I’ve never withdrawn from my emergency fund.
You’ll be able to hang out with a Roth IRA and an emergency fund for a while, just contributing to both of them and watching those numbers go up. You should keep some money in your checking account to pay for day-to-day expenses, but you’ll want to make sure that your IRA and emergency funds are eventually holding the bulk of your cash.
I’m at the point where even if I contribute the maximum amount to my Roth IRA, I still want to invest more money so I’m not hoarding cash in my checking account. For this, I opened another, generic brokerage account with Vanguard: I still invest my money in their index funds, but it’s not a special retirement tax account, it’s just a normal account: I pay my income tax before the money goes into it, and my capital gains tax when money comes out. I also have a 401k from work, and I have a Robinhood account with a few hundred dollars in it so I can pretend like I’m one of the smart finance people and pick my own stocks. But my financial life isn’t any more complicated than that, and my money is doing as much work for me right now as I feel comfortable with it doing.
- The Reddit Personal Finance Flowchart
- A Twitter thread outlining a still-very-basic but also more-complex Vanguard index fund guide
Source: https://media.bac-assets.com/DigitalDeposit_CA_CA_Bay_Area.pdf ↩︎
Source: https://www.salliemae.com/banking/certificates-of-deposit/ ↩︎