Let me start off by saying I am not a financial advisor. To add some credibility I will borrow from the wisdom of others when it comes to investing – the value of which lies in the power of compound interest.
Compound interest is the eighth wonder of the world. He who understands it, earns it…he who doesn’t…pays it.-Albert Einstein
My wealth has come from a combination of living in America, some lucky genes, and compound interest.Warren Buffet
Compound interest allows for exponential growth of your money over time. The rate of growth can be substantially different depending upon the account you invest in. In a standard checking account with $1000 earning an interest rate of 0.5% you might expect slightly less than $1200 at the end of 30 years. That same amount invested in a savings account with average annual interest of 0.9% would yield a little under $1300. However that amount invested at the average rate of return of the S&P 500 (7%), a large basket of stocks that is the most commonly used to gauge the health of the stock market, would leave you with over $7,000.
This example of compound interest highlights two important principles. First, earning the average rate of return in the stock market is anything but average. It leads to tremendous wealth generation. Second, a long-term perspective with investments early on in your career often end up being the most valuable because they have the ability to grow at a compound interest rate.
For a young physician who has seen their salary increase from that of a resident/fellow to an attending, this is a valuable and unique opportunity to get started with investing. For some physicians this may be their first time investing – for others this is the first time they will be investing substantial amounts of money. Regardless, both situations can be quite daunting. However, finding strategies that will allow you to implement the power of compound interest will allow you to more easily achieve the financial freedom that many of us seek.
To invest, according to the Merriam-Webster dictionary, means “to commit (money) in order to earn a financial return.” There are a variety of ways one can commit money – historically, investing meant putting money into equities (stocks), fixed income (bonds), or cash equivalent (money market) instruments. Other common investment vehicles include real estate, commodities (corn, metals etc), futures, derivatives and even cryptocurrency. We will discuss some of these other options in future articles.
Stocks, Exchange Traded Funds (baskets of stocks that are passively managed), Mutual Funds (baskets of stocks that are actively managed), Options, and Bonds are the most common asset classes. The mantra of diversification to prevent any sudden catastrophic loss of wealth always holds true but means different things at different stages in your career. Longer investment time horizons allow you to take more risk and invest more in stocks than bonds for instance. Unless you are actively following the market and doing your own homework on the companies you invest in (often hard for the typical physician with a busy practice) you may want to consider safer, less volatile investments than individual stocks and even more risky options investing.
The use of mutual funds and exchange-traded funds (ETFs) nicely fits in this space because the investments cover a basket of stocks minimizing the risk of an individual stock single-handedly destroying your investment portfolio. There has been a general shift away from active investing (mutual funds) towards passive investment (exchange traded funds) for a few reasons. First, mutual funds tend to have higher fees. The average ETF fee stood at approximately 0.25% compared to average mutual fund fees of 0.85% in 2016. Fees, whatever their percentage, erode from your total rate of return and over long periods of time this can be particularly devastating. Second, nearly 90-95% (depending on the study) of mutual funds don’t beat the S&P 500.
Finally there are tax advantages that will affect high income earners because there are fewer distributions of funds, such that when you finally sell, more money will be taxed at the long term capital gains tax rate which in 2019 remains 20% in the highest bracket, rather than at standard income rate which has a maximum of 37%.
While there are other pros and cons, the lower fees of ETFs coupled with the lack of market beating returns and adverse tax consequences of mutual funds make investing in ETFs generally preferable.
Types of Exchange Traded Funds
There are a plethora of ETFs for investors to choose from. Some are industry specific (technology, financials, etc), some are based on the size of companies in the ETF (small, mid, and large cap stocks), and some track indexes such as the S&P 500, Nasdaq, and Dow Jones Industrials. I want to focus in on index investing because these principles will be true in nearly all market conditions.
As an example, let’s look at investing in index funds that mirror the S&P 500. Why? For the reasons outlined above, namely, that there is an excellent rate of return per year over the long run (better than 7% over the past 30 years and about 10% over the past 50 and 100 year time frames). Second, earning the market average would be exceptional because the majority of active fund managers (19 out of 20 )can’t beat it. Finally the fees involved in investing in S&P 500 ETFs are among the lowest among all ETFs.
The three top ETFs that track the S&P 500 are SPY (State Street Global Advisors), IVV (BlackRock), and VOO (Vanguard). The fees for all of these are quite low- 0.09%, 0.05%, and 0.04% respectively.
I’ll end with a final example – $10,000 invested 50 years ago in the S&P 500, would today be worth $1,555,700. More importantly, when sold this translates to $1,236,560 after tax income. You should do the math and see if investing makes sense for you and your family.
Finally, before diving into the world of investing one should always remember that a key to long term wealth generation is limiting mistakes rather than chasing outrageous returns. Warren Buffet’s two rules on investing sum this up nicely:
- Never lose money!
- Always remember rule no.1
- Investing is a key to achieving financial freedom
- Compound interest is a powerful force that allows income to grow into wealth
- Exchange traded funds such as the SPY, IVV, and VOO can be exceptional tools to achieving sizable rates or long term return