Working towards financial independence

I was recently talking to someone starting their career (in the US) about the best way to invest their savings. The conversation made me reflect on what I've learned about this over the years. I'm not a financial advisor, so what follows is merely my opinion about what I would tell the past me about what I should do with my money. My goal, of course, would be long-term growth of my savings to hit some target number (like $1,000,000) so I could achieve financial indepenence, meaning I could completely stop working if I wanted to (similar to FIRE). I think this Vanguard website has great summary of what people need to know. For more details, I'd recommend this book: The Bogleheads' Guide to Investing.

Practically speaking, there are four activites that are required:


1. One time: Choose your risk tolerance

This is a personal decision, but it comes down to this: Until you hit your target number you need to never touch your invested money, even when the market is down. There will be years where your portfolio has lost nearly half of its value and you might panic and feel like you need to sell your investments to preserve what money you have. But it's really important you never sell when things are down. You need to stay the course, even when things are bad, and continue investing money and rebalancing (the activites explained below).

If you think you're not going to be comfortable with letting it ride in these situations, then going with a traditional 60%/40% split of stocks/bonds is probably the best choice. But I'd advise going with 80%/20% stocks/bonds if you're young and just getting started, in order to maximize the potential for growth over time. You have a lot of life ahead of you to recoup losses if things go wrong. If you're super comfortable with taking risks, maybe even 90%/10% is appropriate.

2. Monthly: Invest your money

You'll need to open a brokerage account so you can buy stocks and mutual funds. Schwab and Vanguard are good choices because they have low or zero fees. Every month, you'll need to transfer cash into your brokerage account, and then buy the right amount of various ETF ("Exchange Traded Fund") stocks. These funds provide sufficient diversification to maximize your growth while minimizing the risk of losing money. The funds offered by Vanguard are excellent because they are well managed, extremely low cost, and accurately track the market. You need to invest every month in order to take advantage of market ups and downs (sometimes called dollar-cost averaging).

Which ETFs should you buy, and how much of each? This is the easy part. Vanguard provides guidance directly in the article above. Your bond portfolio should have 70% in U.S. bonds with the BND fund and 30% in international bonds with the BNDX fund. Your stock portfolio should have 60% in U.S. stocks with the VTI fund, and 40% in international stocks with the VXUS fund.

Using the brokerage website (or app) each month, you'll need to put in 4 orders to buy the right amount of each of these funds to match your risk tolerance. To do the math for you: If you chose an 80/20 split and wanted to invest $1000, then that means $140 in BND, $60 in BNDX, $480 in VTI, and $320 in VXUS. If you chose a 60/40 split, it would be $280 in BND, $120 in BNDX, $360 in VTI, and $240 in VXUS. Make sure you set your orders to "automatically reinvest earnings", which will cause the brokerage to purchase more of a fund each time it yields a dividend or bond payment.

3. Yearly: Rebalance your portfolio

This part might sound tricky but it's not that bad once you think about it for a second. Over time the funds you own aren't going to grow at exactly the expected rate. So after a year of saving and investing, you're going to have too many bonds, or too much international stock, etc. Similar to how you might taste a soup as it cooks to see if you need to add salt or other ingredients, once a year you make sure that you own the right proportion of funds in your portfolio to match your risk tolerance.

Here's a simple way to do this: Take the total value of your portfolio—let's say it's $15,000. Now pretend like you're investing that amount of money for the very first time. If your risk tolerance is 80/20, then following the ratios above, your ideal portfolio is 15*$140=$2,100 in BND, 15*$60=$900 in BNDX, 15*$480=$7,200 in VTI, and 15*$320=$4,800 in VXUS. Compare what you actually have invested in each of these funds to these ideal amounts. If there's a large discrepancy (say more than 10% difference, which would be $1,500 in this example), then you sell that much of the over-concentrated funds, and use the proceeds to buy the funds with too little concentration.

Rebalancing your portfolio like this does cause you to generate income from the stock sale, which can increase your taxes. That's part of why you do it infrequently. But it's worth rebalancing so your portfolio can achieve the gains you want with the risk you can tolerate. There are various apps out there that will do this periodic investing and rebalancing for you — brokerages like Schwab and Vanguard also have these features built-in. There are also people called certified financial planners ("CFP"s) who can help you do all this, but often it's predatory with high fees that are best avoided.

4. Pay your taxes

Your taxes are going to get more complicated if you invest in stocks and bonds. You'll need to fill in additional forms to report your stock portfolio gains and losses. TurboTax does this very well and it's cheap. If you're worried about doing it wrong you can hire a professional tax preparer, but I think that's overkill. You might also want to invest in a retirement account like a Roth IRA or Roth 401K so your savings grows tax free, but that's a different goal than achieving financial independence when you're young.