The average person can read 238 non-fiction words per minute. That gives me 4,046 words to take you from investing zero to hero. We’ll do it with room to spare. Grab some coffee. Three, two, one…
:00 The big picture
You live in a capitalist society. This means that capital— money — can flow from those who have an excess to those who have too little. When you needed funds for college or a home, capital markets were there to lend you the cash. Of course, you had to pay interest on that debt.
On the flip side, you will eventually have savings you can invest in these markets. This is called passive investing, and this time you’re on the receiving end of the interest and other rewards. The most common investing goal is funding your retirement, the focus of this post.
One type of capital market, where you lend money to governments and corporations via contracts called bonds, is called, not surprisingly, the bond market. Another type, where shares of stock (partial ownership in corporations) trade hands, is called, you guessed it, the stock market.
While bonds pay interest to reward investors, stocks pay dividends. Stock prices also usually increase over time, providing another way to profit from them. These price increases are known as capital gains. Dividends (or interest in the case of bonds) plus any capital gains — the total amount you earn from an investment—is your total return.
Example: You buy 10 shares of WidgetCo stock for $10 per share, or $100. During the year, WidgetCo pays you $2 in dividends. When you sell after one year, the stock price has risen to $11. What was your total return?
You made $2 in dividends, plus $10 in capital gains (the stock price increased by $1, and you owned 10 shares), for a total return of $12.
Let’s try another: You buy a $100 US govt bond, (called a treasury), maturing in 10 years. It pays $5 per year in interest. At the end of 10 years, you get your $100 back. What was your total return? Simply $5 per year times 10 years, or $50.
Bonds, especially the types we’ll be investing in, are low risk. Stocks, on the other hand, are high risk. Companies go bankrupt, or suffer severe reversals of fortune, all the time. With this higher risk comes a higher expected return.
Because stocks are risky, you must diversify by owning a large number of them. Diversification is done via mutual funds (“funds”), which allow you to own thousands of stocks with even a small investment. For this service, funds charge an expense ratio, an annual fee they withdraw from your account. Expenses can be a drag on investment returns, so it’s important to own funds with expense ratios of less than 0.1% per year.
Many people use bond as well as stock funds. This isn’t strictly necessary, but it sure is convenient, especially once you’ve opened an investment account with a fund company like Vanguard, Fidelity, or Schwab. We’ll use Vanguard in the examples below.
Funds come in two flavors, traditional, which you buy and sell directly from a fund company, and exchange traded funds (ETFs), which trade like stocks on the stock market. It doesn’t matter much which you choose. We’ll use ETFs in this guide.
Funds, like individual stocks, are often identified by their ticker, or symbol. For example, “BND” is the symbol for the Vanguard Total Bond Market ETF.
The mix of stocks and bonds you hold is called your asset allocation. Typically, you’ll own a high risk, stock heavy portfolio when young, adding bonds as you age. Stock prices can fluctuate wildly in the short term, and are only appropriate for long term spending goals like retirement. Money to buy a house next year should never be invested in stocks.
Over time, your stock/bond mix may get out of whack, and you’ll need to rebalance, or sell down one investment and buy another. I’ll explain how below.
A final note: Many investors trust “financial advisors” with their wealth. This is a mistake. Advisors are mainly salespeople who often put your money in high fee, inferior investments. They have no secret knowledge you can’t possess with a little study, and there’s no point in sharing the growth of your wealth with these folks—it’s easy to invest on your own, and you’ll wind up with far more money.
:03 Which Stocks and Bonds to Hold?
Some stock funds include only segments of the market. There are “growth” stock funds, small stock funds, energy funds, funds that track popular indexes, or lists of stocks, like the S&P 500. You should avoid these, and hold only total stock market (TSM) funds — those that own every investable stock, not just a portion of them.
Holding only a fraction of the market is pointless because the stock market is efficient, meaning it hasn’t left you a “free lunch” in any of its many corners. This is a rather abstract, but critically important concept. An example will clarify:
Newbie Ned is investing in his first mutual fund. He’s immediately drawn to “dividend funds”, funds that hold companies paying high dividends. Surely, he thinks, these will perform better than the market as a whole.
Ned is destined for disappointment. All stocks have similar risks, and thus are priced to yield similar expected returns. If the expected return of one stock somehow became higher than another, the market would instantly adjust — bidding up the price of the superior stock until its expected return was the same as the rest.
Investors who don’t understand market efficiency make all kinds of mistakes. For example, they chase performance, investing based on what’s done well over the recent past. This is a fool’s errand: the market has priced yesterday’s hot stock or industry to perform the same as any other going forward.
Market efficiency also means we shouldn’t care about when to invest. New investors often wonder if they should wait until some event happens to buy into the market. Bad idea. Always invest as soon as you can. Markets have priced in all current and future information. It’s time in the market, not timing the market, that matters.
Market efficiency makes it clear that we should never own individual stocks. Everything you know, think or believe — and a thousand times more — about any public company is already reflected in its stock price. Stock picking is gambling, nothing more.
The investment industry desperately wants to convince you that markets aren’t efficient. That they’ve got a magical strategy for picking stocks or market segments that will lead to easy riches. They don’t, and the data is conclusive on this point.
Ok, you may be thinking, if all stocks are all priced to yield the same return, why own the whole market? Why can’t I just bet it all on the ProShares Pet Care ETF (adorable ticker: PAWS)?
Because the more of the stock market you own, the more unique company risk you wring out of your portfolio, with no loss of returns — and that is a free lunch! One study found that going from 20 stocks to the whole market gave the equivalent of an extra 2% return per year.
We use only TSM funds for other reasons. First, they’re low cost. You can own one for under .05% per year. Second, they’re tax efficient. Funds that must buy and sell stocks frequently to stay within certain parameters incur taxable capital gains, and those may get passed on to customers. Finally, owning a single TSM fund prevents the mess many investors end up with when they own many funds, each holding a different, often overlapping portion of the market. Piling on more funds does not maximize diversification. Only owning the whole market does.
The US isn’t the only country with a stock market, and it’s prudent to have some international diversification as well, by holding foreign stocks in addition to domestic ones. Sometimes, without warning, single countries have long periods of awful returns while the rest of the world powers forward (see Japan below). Mutual funds make owning foreign stocks easy.
Now let’s tackle bonds. Which type to choose? First, we’ll want to limit our interest rate risk. Imagine you buy a bond with a maturity date 30 years from now, paying 5% interest. Rates jump to 10% the next day, but you’re stuck with that lousy 5% return for three decades. To avoid this, we’ll stick to shorter term bonds.
Second, we’ll certainly want bonds where the borrower is going to pay us back! In other words, those with low default or credit risk. A treasury has virtually no credit risk — the US govt can print money. On the other hand, the bonds of a failing public company might be risky indeed. Even those, however would be less risky than that same company’s stock, since if a company goes bankrupt, bond holders get paid before shareholders receive a penny.
Anyway, it’s prudent to stick with low risk bonds. Your bond holdings will form the solid foundation of your portfolio. We’ll “take our risk on the stock side.”
Just as we invest in TSM funds for stocks, we’ll invest in TBM (can you guess what that stands for?) funds for bonds. TBM funds hold just the sort of low risk, shorter term bonds we desire, and as one bond matures, the fund buys another, so we stay fully invested.
Are there valid alternatives to TBM funds? Sure. You could use bank CDs, money market accounts, individual bonds, or other so called fixed income investments. TBM funds are simplest for most though.
A final bond note: Most bonds just pay a fixed rate of interest, but one type of treasury, called TIPS, adjusts each year for inflation as well. A TBM fund should return about the same as a TIPS fund over time, as higher inflation usually leads to higher interest rates, but some investors own TIPS as well as “conventional” bond funds.
Putting it all together, you want three types of investments: US stocks, foreign stocks, and US bonds. This is known as a three fund portfolio, since, historically, you needed to buy one fund of each type.
These days, you can own a single fund containing both US and foreign stocks. Taking things a step further, many people hold their “three fund portfolio” in a single, all in one product known as a Target Date Fund (TDF), which has both stocks and bonds, and becomes gradually less risky as you age. TDFs also rebalance for you, making your portfolio completely maintenance free.
You might be wondering why we don’t add foreign bonds to our investments. Well, they’re not really required — recall that diversification is less important with low risk bonds. However, a small allocation to them doesn’t hurt, and some will probably be included in your TDF, if you go that route.
Before we continue, it’s worth mentioning why we prefer stocks and bonds to other types of investments. What about gold and cryptocurrencies, for example? Well, these are mere speculations, not investments. They don’t produce income, and depend solely on the greater fool theory.
How about real estate? Owning a home can be a good idea, and many people get into the landlord business. But this requires effort; it’s not the type of hands free passive investing we’re discussing here.
Finally, many investors get suckered into whole life, annuities, and other life insurance contracts with an investment component. These are high fee, opaque contracts which should be avoided — keep your insurance and investments separate.
:07 Asset Allocation
Stocks and bonds are our investments of choice. But what mix of these two mighty assets to hold? Recall that we expect higher returns from higher risk stocks. This is known as the equity risk premium (ERP), and it’s averaged around 4% per year historically, across many countries.
Example: As I write, the Vanguard TBM fund has a 4.5% annual interest rate (find this by looking for the fund’s “SEC yield”). Thus we expect stocks to return around 8.5% over the long term. We probably won’t get that outcome — risky stocks could return 2% or 14% per year, but 8.5% is a reasonable guess.
A 4% ERP is a big deal. $10k growing at 4.5% for 30 years is worth $37k, but worth $115k growing at 8.5%. Looking at these numbers, you might wonder why we’d ever hold bonds?
Risk, of course. Consider:
With these sobering facts in mind, how to determine your asset allocation? Here are the guidelines:
When you’re young, with most of your earnings ahead of you, own a stock heavy portfolio. You’ve got “insurance” against any sharp decline, since you’re contributing new savings on a regular basis. Young people may even hope for a market crash, allowing them to “buy low”. While anything can happen to stocks in the short term, in the long term they’re usually the better performing investment. For example, they’ve beaten bonds 90% of the time over 10 years in the US, and 100% of the time over 20.
Now imagine the opposite situation: You’re retired, and the stock market enters an extended decline. You can’t benefit from low stock prices — in fact, you must sell down your investments to pay your living expenses. It’s a good idea to have plenty of stable bonds during this phase of life.
You see the pattern. You’ll want to gradually add bonds as you get older. A good rule is to take your age, subtract 20, and hold that percentage in bonds.
Example: Sue is 45 years old, so her asset allocation would be 25% bonds, 75% stocks.
Could Sue hold 100% stocks? Sure, but as she approaches retirement, this would be an increasingly risky proposition. Imagine a severe recession in 5 years causes a 50% stock market decline and costs Sue her job. She’d planned to work until 65, but finding work at her age was hard, and she found she needed to draw down her portfolio sooner than expected. Would Sue be happy she’d invested part of her savings in safe assets? Definitely.
Could Sue hold only bonds at 45? Again, sure, but she’d probably have to save a lot more each year. You’d need to put away $20k/year for 30 years to wind up with the same final amount at a 4.5% annual return as saving just $10k/year at 8.5%. But note the probably in the statement above. There’s no guarantee that stocks must outperform bonds, even over the long term.
:10 Taxes and Account Types
To to grow your wealth quickly, you’ll want to minimize the taxes you pay. You’ll do this mainly by investing in tax advantaged accounts (TAAs), which were created to encourage people to save for retirement.
Regular taxable accounts force us to pay taxes on our investment gains every year. TAAs allow us to pay taxes only once, either in the year we make the investment (a “Roth” type TAA), or in the year we sell (a “traditional” TAA). Avoiding annual tax bills is a free lunch, because the taxes you would have paid early can continue to grow.
Example: Bob has two $100 investments, each paying 10% interest per year for 30 years. On one he pays taxes each year on the interest. On the other he pays the taxes only once, at the end of the 30 years. Which investment is better?
At a 40% tax rate, Bob winds up with $542 with the annually taxed investment, and $892 with the tax deferred one. That’s a huge difference!
To review: Traditional TAAs give you a tax break when you contribute, reducing your taxable income that year. You have to pay taxes on your Roth TAA contributions, but the money you withdraw in retirement will be tax free. And you don’t pay taxes along the way with either type.
TAAs include employer sponsored plans (ESPs), like 401ks and 403bs, and IRAs, which you open directly with an investment company. Note that these accounts have restrictions — you generally can’t withdraw the money until age 59.5 without penalty (there are exceptions).
You’ll want to contribute as much money as possible to these plans, but you’re limited on how much you can add each year. For example, the max IRA contribution in 2025 is $7,000, while the max ESP employee contribution is $23,500 (a bit more if you’re over 50). IRAs also have income limits.
Should you choose a Roth or traditional type TAA?
If your marginal income tax rate will be the same in retirement as it is while working, it doesn’t matter. That’s just how the math works. Most people will probably be in a higher tax bracket during their working years than in retirement, so should choose the traditional type. State income tax rates are also worth considering. If you’re working in a high tax state, and may be retiring to a lower tax one, a traditional account makes sense.
A few notes on ESPs: Many employers match the amounts you contribute to up to a certain limit. Never miss out on this free money! Also, when you leave your employer, you’ll roll over your 401k or similar into an IRA — everything becomes an IRA eventually. Finally, note that mutual fund choices within ESPs can be less than ideal, with limited options and high expense ratios. Here, you’ll just have to analyze the funds offered and find the one closest to the low cost total market funds we favor here.
For some people, TAAs are enough to take care of their lifetime retirement investing needs. But if you want to invest beyond TAA contribution limits, you’ll also need a taxable account. And this raises a couple of important points. First, you should keep your stocks in your taxable account, your bonds in your TAAs. Consider:
The stocks-in-taxable rule is known as asset location. Remember those convenient, all in one TDFs? They’re fine if you have only TAAs, but you’ll probably want separate stock and bond funds if you have both taxable and TAA accounts to practice good asset location.
Putting it all together, you may end up with as many as three accounts in retirement: One taxable, one traditional IRA, and one Roth IRA. Regardless, you must always allocate across the whole portfolio.
Example: Ray, age 50, desires a 70/30 asset allocation. He’s got $100k in a taxable account, and $100k in a 401k at work. How should he invest? He certainly shouldn’t buy 70% stocks and 30% bonds in each account!
Instead, Ray thinks in terms of a single, $200k portfolio. He wants 70% of that, or $140k, in stocks, and 30%, or $60k, in bonds. Asset location rules dictate that he favor bonds in his retirement accounts, so he buys $60k of a TBM fund in his 401k. He spends the remaining $40k in his 401k, and the $100k in his taxable account, on a global TSM fund.
A final note about TAAs: It’s possible to convert your traditional TAA to a Roth type. Read more here.
:14 Putting It All Together — Step by Step investing
Now that you’ve got the investment principles down, let’s turn to some practical examples. We’ll take two scenarios, a simple one, so you can learn the basics, and a more complex case, with twists that may apply to you.
Example 1: Simon, 23, earns $75k per year, and can save $12k/year for retirement. He has no savings yet. How should he start investing?
Simon first checks for available TAAs, and finds he has a traditional 401k at work, which matches 100% of the first 6% invested. He’s also under the income limit for IRA contributions.
Simon’s not sure if his income tax rate will be higher or lower in retirement than today. So he opens a Roth IRA at Vanguard and will contribute the $6k maximum there. He’ll contribute the remaining $6k he wants to save to his 401k, getting the match and tax deferral benefits. A mix of Roth and traditional TAAs can be useful in retirement. He invests in TDFs in both accounts.
Example 2: Cathy, age 55, has accumulated quite a few assets after 30 years of work. She’s got $1.2M in a taxable account invested in individual stocks, $250k in a couple of old 401ks, $250k in a Roth IRA, and $300k in the 401k at her current job. She earns $300k/year, and wishes to save $100k/year for retirement. She opts for a 65/35 portfolio. How should she invest?
Cathy tackles the 401ks first. She sees they’re invested in a hodgepodge of high fee funds, so sells them, and then rolls the cash into a Vanguard IRA (call Vanguard if you need help doing this, it’s easy).
Then she takes a look at her taxable portfolio. She’s got two choices, neither ideal. If she sells the stocks and buys a TSM fund, she’ll have to pay capital gains taxes on the sales. If she leaves them, she’ll defer the taxes, but will be stuck with individual stock risk.
Cathy decides to sell 2/3 of the stocks — the ones with the lowest capital gains.
Then she assess her current portfolio:
That’s a total portfolio value of $2M. She wants 65% stocks, or $1.3M, and the rest, $700k, in bonds. So she buys the Vanguard Total World ETF (VT) with the cash in her taxable account, and the remaining $100k in her Roth IRA. She fills the rest of the Roth, her IRA, and her 401k, with a TBM fund.
Cathy’s portfolio isn’t perfect — she’s got $400k of individual stocks, in addition to her three fund portfolio. But she decides she can live with these. When she retires, she’ll sell down those individual stocks first.
Once you get your portfolio set up, there’s not much to do year to year except rebalance as needed to say near your desired asset allocation. You can rebalance yearly, when you notice your stock/bond ratio is out of balance by 5-10%. You may also want to tax loss harvest once in a while (follow link above).
Finally, you’ll retire, and get to spend down your savings. Generally you can spend 4% of your initial retirement nest egg each year if you retire at 65, but closer to 3% if you retire early at, say, 50. So make sure you save enough to cover your retirement spending needs after accounting for social security and any pensions.
Example: Rob retires at 65. He’s saved $2M. He can spend $80k per year of that portfolio (2M * 4%) in the first year of retirement. Each year, he’ll adjust that $80k for inflation as a general spending guide.
The key idea in retirement is to spend flexibly. In times where your portfolio has good year, you’ll spend a bit more, and vice versa. Also, keep in mind that at after age 73 you’ll be forced to begin withdrawing money from your traditional TAAs.
And that’s a wrap. The information here doesn’t include every possible investing scenario, product, rule or wrinkle. But covers the critical fundamentals, and knowing it puts you ahead of 99% of your fellow retirement savers. I hope it was worth your 17 minutes.