Investing Playbook for Young Professionals

This is a set of financial principles and a playbook for people who:

• Have discretionary money left over after paying living expenses, and
• Don’t have any big expenditures planned for the near future (e.g. buying a new house)
• Don’t know what to do with that money

This applies to a lot of people I’ve worked with who are early in their professional careers. For young people, starting to invest your money is way more important than changing your spending habits to increase savings.

Whether you have a lot of money left over after expenses or only a little, the playbook applies regardless.

Principles

Start early

The way money grows over long time horizons is not intuitive because compounding returns are not intuitive.

Compounding applies both to interest and investment returns. It’s hard to have a good intuition about compounding for the same reason it’s hard to have good intuition about any other super-linear growth curves. Most people understand that compounding can be good for them, but they don’t understand how good it can be.

(If you studied CS, you have an advantage because you’ve learned about algorithm runtimes and you’ve seen how compounding can work against you (i.e. superlinear runtimes).

You want to start benefiting from compounding as early as possible. An example:

Scenario: You invest $500 every month for 40 years, for a total contribution of $240,000.

Downside case: If you put that money in a checking account at 0.2% APY (this is very high compared to most standard checking accounts), you’ll end up with roughly $250,000 after 40 years. You gained $10,000.

Upside case: If, instead, you get a 10% annual rate of return (the historical stock market return is roughly 7-10%, so this is slightly optimistic), you’ll end up with $3.2 million in the same time. You gained almost $3 million.

Small differences in your rate of return make a massively outsized impact on your total return. The rate of return in the upside case is 50x greater than the downside, but the returns over 40 years are 300x greater. That’s due to compounding.

Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it.
– Einstein

The SEC also wants you to understand this, so they made a nice calculator.

Even with modest contributions, it’s worthwhile to start exposing yourself to the higher returns of the stock market as soon as possible.

Invest with a long time horizon

Most investors manage their risk tolerance by balancing two types of investments:

If you invest with a robo-advisor (e.g. Wealthfront, Betterment), you’ll go through a flow to determine your risk tolerance. They’ll ask you questions like: “How would you feel if you lost 20% of your portfolio value due to recession?” Depending on how you answer those questions, they’ll allocate your money into a mix of primarily cash and stocks.

If your risk appetite is aggressive and your time horizon is long term, you’ll likely end up with around 10% cash and 90% stock.

In my experience, for someone early in their career, this is still too conservative. If you truly have a long time horizon, you can allocate your investments essentially entirely to stocks. Even if there is a downturn in the market, you will have enough time to participate in the recovery from that downturn before you need to withdraw.

Don’t try to time the market

Most of investing mistakes people make come down to making decisions emotionally, rather than rationally. For example, if you get demoralized and sell off your stock portfolio in the depths of a recession, you’ll lock in your losses and miss out on the market recovery. Typically, after hitting bottom in a recession, the market has recovered all its loses in months to a few years. When you invest with a long time horizon, your timing doesn’t matter.

In order to counteract the human predisposition to emotional decision making, it’s beneficial to decide on a strategy and then rotely implement that strategy without wavering.

One powerful strategy to invest unemotionally, is called Dollar Cost Averaging. This investment strategy involves buying stocks regularly, at consistent intervals, thus smoothing out your exposure to price fluctuations. For example, if in a year you are going buy $12,000 of VOO, you can either:

1. save up all year and buy on December 31st, or
2. buy $1,000 per month for 12 months

Executing plan #2 means you’re Dollar Cost Averaging and you end up with the average price over the year instead of whatever the price was that one day in December.

If you don’t have a large amount of money to invest all at once, this is a good strategy to use. Make investments on a continuous basis (ideally set up programmatically with auto-invest features) and don’t worry about the price.

If you do have a large amount of money to invest all at once, you have to decide whether to invest all at once (lump sum) or to invest over time to get the average cost. Consensus is now that lump sum investing outperforms than averaging in this situation.

Minimize Fees

It’s impossible to control or predict market performance, but the one thing you can control is fees. Fees are leveraged whether the market goes up or down. A fee charged this year reduces your assets for next year. So, fees also work with compounding, and thus, it’s easy to underestimate the cumulative effect they have.

My biggest rule is: Never pay a financial advisor a percentage fee of your account value.

If you want a professional to help you, pay a financial planner by the hour. It might be something like $150/hour, but this will be much less than whatever you’d pay over time with a percentage based fee.

If you use a money manager who charges 1.3% per year, you are paying 43x the expense ratio of an index fund, like VOO (expense ratio of 0.03%). But you also still have to pay the expense ratio for the underlying funds the manager chooses for you. You also don’t have control of the fee load of those funds. They may choose funds that have higher expense ratios—maybe the funds are operated by their company and they are encouraged to park people’s money there.

A robo-advisor lowers those percentage based fees to roughly 0.25% (plus the fund expense ratios), but this is still higher than 0%, which is what you pay if you just buy VOO with a brokerage account.

There is absolutely no guarantee that the money manager or the robo-advisor will do better than the S&P 500.

In fact, in 2008 Warren Buffet wanted to prove this point, so he challenged any active money manager to a bet: They would each start with $1 million and whoever could achieve higher returns over a 10 year period would get to choose the charity to which all the money would be donated. Buffet just bought an S&P 500 index fund against the fancy money managers active management. His competitor gave up in 2015 and Buffet won the bet with a single trade.

The S&P 500 is the standard upon which all other investments are measured. Even if you just match the S&P 500 returns, you’ve done well and no one can fault you.

(This the whole idea behind the “VOO and Chill” philosophy in FIRE communities.)

The Playbook

Okay, we now have all the principles we need to be able to roll out the playbook.

The playbook is organized as a waterfall of priorities. We’ll start at the top, which are our most urgent priorities. Once we satisfy one priority, we’ll move on to the next one, until we’re at the bottom.

You can think of your income as water and the priorities as buckets. Once you’ve filled the first bucket, the water should overflow into the second bucket. If you later scoop some water out of the upper buckets (e.g. withdraw from your emergency savings account) you’ll want to refill that bucket before letting more water flow to lower buckets. The bottom bucket is elastic, so it’ll never overflow.

1) Pay down “expensive” debit

Just as compounding can be a powerful force for good when investing, it can also be a powerful adversary when it’s applied as an interest rate on a loan.

Generally I’d consider an “expensive” loan to be anything that is higher than the historical rate of return of the stock market, so ~7%.

Credit card loans, for example, are often above 20% and should be avoided at all cost. (There’s no interest if you pay off in full by your due date.) If you have credit card debit that you carry from month-to-month, pay it off first. Before you continue down the list toward eventually making investments, you should be paying off your credit card in full, on time, every month.

(There are also “cheap” loans and these can be advantageous to keep around. This doesn’t mean you have to pay off all your loans, just the expensive ones.)

2) Make an emergency fund

Next, open a dedicated high-yield savings account and accumulate 3-6 months of living expenses in that account. As of June 2023, you should expect to get above a 4% interest rate in a good high-yield account. Wealthfront is currently offering 4.55% APY.

This should be separate from your primary checking account, out of which you pay rent and credit cards.

You won’t touch this money unless you lose your job or have some other emergency. If you’re starting from nothing, you can start on the 3 month side and then move on down the waterfall, but think about bumping this up in the future.

Having an emergency fund is a drag on your returns, but it gives you flexibility. In the future, you may not need to sell stocks at a bad time in order to cover your expenses, as long as you have emergency funds available.

3) Max out your 401k

Next, if your company offers a 401k plan, you should contribute as much as you can. If you can afford to max it out, do it.

401k accounts are tax-advantaged and typically come with other benefits, like employer matches. In employer match programs, your employer will contribute a certain amount (usually a percentage of your annual salary) into your 401k, no strings attached. It’s free money.

Typically they’ll contribute a prorated amount per paycheck, so make sure you spread your contributions across the whole year. If you hit your limit in June, you’ll miss out on 6 months of matching!

There are some nuances to 401k accounts that you should be aware of. You should generally think about this money as being reserved until retirement. There are some ways can withdraw early, but that’s outside the scope of this post. Don’t be dissuaded by these limits.

There are two types of retirement accounts and you can elect to use one or both of them: Traditional and Roth. The important thing is to play the game; choosing the “right” one is hard to do and is a micro-optimization. Depending on your future earnings, your election could be optimal, or sub-optimal. Either way, as long as you’re contributing, you’re doing a good thing. Here are the types:

Traditional 401k: Money going into the account is not taxed (pre-tax), but future withdrawals are taxed. The way this works is, at tax time, you contributions reduce your taxable income, but you pay taxes on your future withdrawals (at your future tax rate).

Roth: Money going into the account is taxed (post-tax), but future withdrawals are not taxed. This means you pay taxes (at your current tax rate) now and then you can withdraw your contributions and gains without taxes in the future.

The benefit of a traditional account is deferring taxes on the money you contribute. The downside is you still have to pay taxes in the future on those funds and all your gains. Maybe deferring taxes now means you’ll end up with a higher amount in the account at retirement and you’ll be in a lower tax bracket when you retire. Or maybe not. It’s hard to predict.

My advice is to split your contributions across both styles of accounts. I’ve historically done about 50/50. Don’t overthink it. Again, don’t let the complexity dissuade you from playing the game.

Pause and congratulate yourself

You’ve still got a couple more steps in the waterfall, but you’ve done all the hard stuff.

4) Invest in an Individual Retirement Account

Note: I’m keeping this at 4 because that’s where it should be, but it can be complicated, so it’s okay if you skip this one and come back to it later.

Outside of your employer-sponsored accounts, you can also make contributions to an Individual Retirement Account (IRA). In 2024, the limit is $7,000/year. For all the same reasons (other than the employer match), you’ll want to take advantage of this tax-optimized account as well.

Just like with the employer-sponsored accounts, there are some nuances here:

You can do a Traditional account with the same tradeoffs as above.

You can also do a Roth account, but there’s an additional hoop you have to jump through. After a certain income threshold, you will need to do special procedure called a Backdoor Roth contribution, where you first contribute to a Traditional IRA and then convert it into a Roth account.

If you want to do a Roth IRA, you need to commit to that in order to be able to continue making Roth contributions. If you have Traditional IRA account balances, it’ll lower the amount of Roth IRA contributions you can make. So don’t convert employer-sponsored 401k accounts into IRAs if you want to continue to do Roth contributions.

Again, don’t let the complexity dissuade you and feel free to skip this for a year or two.

5) Invest on your own

You’re done with all the tricky tax-advantaged stuff and you can just invest normally now.

The default way you should invest this money is the Warren Buffet strategy: Just buy index funds that give you broad exposure to the market. This could be an S&P 500 index fund like VOO. It could be a broad market index fund, like VTI. In theory, a broad market index fund gives you more diversification because you have exposure to more than 500 companies. In practice the historical returns aren’t much different.

Optionally, if you want to have some fun picking and choosing stocks or investing in Bitcoin, you can do that too. But set guard rails. Decide ahead of time on a percentage of money that reaches this bucket which you will invest in index funds and a percentage that use for picking and choosing.

Assume that you might lose a large percentage of the picking and choosing bucket. That’s okay, you’ll learn valuable lessons by experimenting and as long as you’ve stuck to the split you chose, you’ll still be investing for the long term.

Feel free to reach out if you have questions.