1. You can’t control the investment markets, so focus on the two things you can control – investment costs and your asset allocation.
No one, and I mean no one, knows what is going to happen in the investment markets. Study after study have shown that the overwhelming majority of people who try to beat the markets fail. Because of this, you should forget about trying to predict the markets, and focus on things you can control – investment costs and your asset allocation.
All investments have costs, and the impact of these costs on your investment return compounds over time, taking a larger and larger bite out of your investment returns. If you invest $100K for 25 years and earn 6% per year, without costs you’d have $430K. With just a 2% annual cost you wind up with only $260K. That 2% annual cost consumed $170K, almost 40% of your potential investment! (Source: Vanguard.com)
In addition, because they have to overcome higher costs, investments with higher costs lag the performance of similar investments with lower costs. If you look at stock and bond mutual funds in the highest and lowest cost quartiles, you’ll see what I mean:
|Type of Fund||Highest Quartile of Cost||Lowest Quartile of Cost|
Average yearly return from 2004-2014. (Source: Vanguard.com)
If you want to take one step that will guarantee that your costs are among the lowest in the industry no matter what you invest it, you should invest with Vanguard or the Thrift Savings Plan (TSP). Vanguard is actually owned by its own investors (you), and they leverage this corporate structure to provide the lowest investment costs across the board with the exception of the TSP, which has even lower expenses.
If you can’t invest with Vanguard outside of your TSP, perhaps because your have access to a retirement plan that doesn’t offer Vanguard investments, then you need to get into the weeds on your investment costs. While there are many different potential investment costs, the easiest one to look at is the expense ratio of your potential investments.
According to Morningstar.com, the expense ratio is “the annual fee that all funds or ETFs charge their shareholders. It expresses the percentage of assets deducted each fiscal year for fund expenses, including 12b-1 fees, management fees, administrative fees, operating costs, and all other asset-based costs incurred by the fund.”
Wow. That was a mouthful. Bottom line…high expense ratio bad, low expense ratio good.
You should be able to find your investments’ expense ratios on your investment website or Morningstar.com.
In addition to investment costs, the other things that you can control is your asset allocation. While there are many asset classes you can invest in, the two most basic are stocks and bonds. Here are some of the returns for stocks and bonds from 1926-2013 in commonly utilized portfolios:
|Annual Return||50% Stocks & 50% Bonds||60% Stocks & 40% Bonds||80% Stocks & 20% Bonds||100% Stocks & 0% Bonds|
As you can see, the higher your allocation to stocks over bonds, the more risk you are taking and the bumpier the ride. Along the way, though, you have historically been rewarded for this bumpy ride with a higher average annual return. Just like the extra 2% cost that was previously discussed compounds to make a huge difference, so will a small difference in your returns. In other words, the more risk you can take, the more money you will probably end up with.
The application of these principles is that you should take as much risk as you can. In other words, you should invest as much of your portfolio in stocks as you can while still sleeping at night and not lying awake worrying about the stock market’s ups and downs. There will be another market downturn, and when that occurs you need to keep buying stocks because they are on sale, not sell out because you can’t handle seeing your net worth and portfolio value decrease.
Invest is as high a percentage of stocks as you can without making the critical mistake of selling stocks during the next market downturn. For me, that has been 100% stocks for the majority of my career, but for some people they’ll panic even at a much lower percentage of stocks. If a 50% stock and 50% bond portfolio is the only one that will keep you from selling during the next market downturn, then that is the right portfolio for you.
If you have been investing for long enough, look at your actual behavior during the 2007-2008 market downturn and what your asset allocation was at the time. Mine was 100% stocks and I kept on buying. Your allocation and actions will tell you a lot about your own risk tolerance.
2. Your savings rate is the most important factor determining your eventual net worth, and it should be at least 20-30% of your gross income.
The most common recommendation you’ll find or hear when it comes to saving for retirement is to save 15% of your gross or pre-tax income for retirement. There is nothing wrong with this recommendation, but built into it is the standard mentality of working until age 65 and then retiring. If you want the freedom to retire early, work as much or as little as you want, and achieve financial freedom/independence, then you will need to save much more than 15%. I’ve saved 30% over most of my adult life, and that’s why I’m writing a personal finance blog post.
If you want to take a look at various saving rates and how they impact your financial life, you’ll want to check out the blog post “The Shockingly Simple Math Behind Early Retirement” at MrMoneyMustache.com. There you will find a chart that shows you how many years you will have to work until you can retire based on your savings rate. If you go with the standard 15% savings rate, you’ll have to work 43 years before you can retire. If you go with my 30% rate, you’ll work 28 years. If you manage to save 50%, you can retire in 17 years! The more you save, the earlier you reach financial independence and can work as much or as little as you want.
The other standard advice you’ll hear and read is that you’ll spend approximately 80% of your pre-retirement income during retirement. For a physician with a typical high income, that can be a lot of money!
You have to realize that 80% is probably high for a physician because after you retire you’ll have greatly reduced expenses. This is because:
- You’ll be in a lower tax bracket.
- You’re no longer saving for retirement.
- You no longer need life or disability insurance.
- You’ve hopefully paid off your mortgage.
- Your kids are out of the house (if you had any).
- You have no more job-related expenses.
- You can give less to charity if you need to.
In the end, you can probably live off of 25-50% of your pre-retirement income, not the standard 80%. This fact can multiply the effect of a higher than normal savings rate.
3. You are your own financial worst enemy.
Unfortunately for us, we engage in self-defeating behaviors all the time, including:
- Assuming too much debt.
- Living above our means in order to keep up with the doctor lifestyle.
- Purchasing too large and expensive a house.
- Purchasing too expensive a car.
- Not maxing out our tax-advantaged retirement account contributions.
Luckily there are some simple rules that, if followed, can keep young physicians and medical students out of trouble.
First, realize that anytime you assume debt you are simply borrowing from your future self for current gain. Sometimes that is a good idea, like when you borrow to pay for medical school, but pausing before you assume debt to purchase something can help you out greatly.
Getting down to brass tacks, no one really cares what medical school you went to, so you should probably go to the cheapest one you can get into.
In addition, no one really cares how large your house is or what kind of car you drive. You think they care, but they really don’t. Don’t try to impress other people.
If you have student debt, you need to get smart about ways to refinance it or get it forgiven with the Public Service Loan Forgiveness Program. Thanks to the HPSP program, I never had student debt, so I’m not going to pretend to be the expert on it. If you have student debt, go to WhiteCoatInvestor.com and learn about options to refinance or get your loans forgiven.
When it comes to houses and cars, if you can’t afford the house you are purchasing on a 15-year fixed mortgage then you are probably buying too expensive of a house. Rent until you can put down a larger down payment or look at less expensive houses.
When it comes to cars, you should realize that you can buy a very reasonable used car that is 5-10 years old, plenty nice, and very reliable for much less than a new car will cost. You should make it your goal to pay cash for cars. If you can’t pay cash, then you should purchase a cheaper car.
Low or no interest loans are tempting because people think they are getting “free money,” but using “free money” to pay for a depreciating asset (one that declines in value) is not a smart financial move. Your goal should be only to borrow money for appreciating assets (ones that increase in value), like businesses or real estate.
Finally, make sure you maximize your tax advantaged retirement contributions every year, like the TSP. It is one of the few legal ways to hide money from the IRS, and the compound growth year after year is an opportunity you don’t want to miss.
In summary, here are the three things every young physician or medical student needs to know:
- You can’t control the investment markets, so focus on the two things you can control – investment costs and your asset allocation.
- Your savings rate is the most important factor determining your eventual net worth, and it should be at least 20-30% of your gross income.
- You are your own financial worst enemy.
Somebody out there is going to take this advice to heart and get rich. Is it going to be you?