The Simple Path to Wealth: Your Road Map to Financial Independence and a Rich, Free Life

by J.L. Collins

If your goal is financial independence, it is also to hold as little debt as possible. This means you’ll seek the least house to meet your needs rather than the most house you can technically afford.

There are many things money can buy, but the most valuable of all is freedom. Freedom to do what you want and to work for whom you respect.

Being independently wealthy is every bit as much about limiting needs as it is about how much money you have. It has less to do with how much you earn—high-income earners often go broke while low-income earners get there—than what you value. Money can buy many things, none of which is more important than your financial independence.

Spend less than you earn—invest the surplus—avoid debt

Stop thinking about what your money can buy. Start thinking about what your money can earn. And then think about what the money it earns can earn. Once you begin to do this, you’ll start to see that when you spend money, not only is that money gone forever, the money it might have earned is gone as well. And so on.

At $56 per share or at $52 per share, you still own the same 186.3238308 shares of VTSAX. That in turns means you own a piece of virtually every publicly traded company in the U.S.—roughly 3,700 the last time I checked.

As those fall away, they are replaced by other newer and more vital firms. Some will succeed in a spectacular fashion, growing 200%, 300%, 1,000%, 10,000% or more. There is no upside limit. As some stars fade, new ones are always on the rise. This is what makes the index—and by extension VTSAX—what I like to call “self-cleansing.”

If I were to seek absolute security (a very different thing than the smooth ride most mistake for safety), I’d hold 100% in VTSAX and spend only the ~2% dividend it throws off. Nothing is ever completely certain, but I can’t think of a surer bet than this.

I want my money working as hard as possible, as soon as possible.

successful investing is by definition long term. Any investing done short term is by definition speculation.

must recognize the counterproductive psychology that causes bad investment decisions—such as panic selling—and correct it in yourself. In doing so, your investments will be far simpler and your results far stronger.

The market always goes up. Always.

The market is the single best performing investment class over time, bar none. 5. The next 10, 20, 30, 40, 50 years will have just as many collapses, recessions and disasters as in the past. Like the good Professor says, it’s not possible to prevent them. Every time this happens your investments will take a hit. Every time it will be scary as hell. Every time all the smart guys will be screaming: Sell!! And every time only those few with enough nerve will stay the course and prosper. 6. This is why you have to toughen up, learn to ignore the noise and ride out the storm; adding still more money to your investments as you go.

she can expect to see 2008 level financial meltdowns every 25 years or so. That’s 2-3 of these economic “end of the world” events coming her, and your, way. Smaller collapses will occur even more often.

Of course, over those same years she’s going to see several major bull markets as well. Some will rage beyond all reason, along with the hype that will surround them.

Then, in 1992, Vanguard created the Total Stock Market Index Fund and investors could own in this one fund not just the 500 largest U.S. companies, but virtually the entire U.S. stock market.

To appreciate why the stock market relentlessly rises requires an understanding of what we actually own with VTSAX. We own—quite literally—a piece of virtually every publicly traded company in the U.S.

Never buy stocks on margin.

In a deflationary environment, delayed buying decisions are rewarded. If you were considering a new house in 2009-13 you would have noticed that prices were dropping, along with mortgage interest rates. Recognizing you could get both for less later, you waited. If enough potential buyers joined you, demand would drop pulling prices and rates down further. Delay is rewarded and action is punished. Too much of this and the market slips into a deadly spiral of crashing prices.

But during periods of inflation, anything you want to buy will cost more tomorrow than today. You have an incentive to buy that house (or car or appliance or loaf of bread) today and beat the price increase. Delay is punished with higher prices later and action now is rewarded. Buyers become ever more motivated. Sellers become ever more reluctant. Too much of this and the market slips into a deadly spiral of increasingly worthless currency people are desperate to exchange for goods.

The Three Considerations You’ll want to consider: In what stage of your investing life are you? The Wealth Accumulation Stage or the Wealth Preservation Stage? Or perhaps a blend of the two? What level of risk do you find acceptable? Is your investment horizon long-term or short-term?

The Wealth Accumulation Stage comes while you are working, saving and adding money to your investments. The Wealth Preservation Stage comes once your earned income slows or ends. Your investments are then left to grow and/or are called upon to provide income for you.

Your life stages may well shift several times over the course of your life. Your investment stage can easily shift with them.

The Three Tools Once you’ve sorted through your three considerations, you are ready to build your portfolio and you’ll need only these three tools to do it. See, I promised this would be simple! 1. Stocks: VTSAX (Vanguard Total Stock Market Index Fund). Stocks provide the best returns over time and serve as our inflation hedge. This is our core wealth-building tool. (See Chapter 17 for variants of this same fund.) 2. Bonds: VBTLX (Vanguard Total Bond Market Index Fund). Bonds provide income, tend to smooth out the rough ride of stocks and serve as our deflation hedge. 3. Cash. Cash is good to have around to cover routine expenses and to meet emergencies. Cash is also king during times of deflation. The more prices drop, the more your cash can buy. But when prices rise (inflation), its value steadily erodes. In these days of low interest rates, idle cash doesn’t have much earning potential. I suggest you keep as little as possible on hand, consistent with your needs and comfort level.

So that’s it. Three simple tools. Two index mutual funds and a money market and/or bank account. A wealth-builder, an inflation hedge, a deflation hedge and cash for daily needs and emergencies. As promised, it’s low cost, effective, diversified and simple. You can fine-tune your allocation in each investment to meet your own personal considerations. Want a smoother ride? Willing to accept a lower long-term return and slower wealth accumulation? Just increase the percentage in VBTLX and/or cash. Want maximum growth potential? Hold more in VTSAX.

Rather than meaning index fund returns are at the midpoint, the word “average” here means the combined performance of all the stocks in an index.

Consider this: Once you begin living on the returns from your portfolio you’ll be able to spend roughly 4% of your assets per year. (We’ll explore this 4% concept in Part IV) If 1% of your money is going to management fees, that is a full 25% of your income.

Some bonds are “callable,” meaning that the bond issuer can pay them off before the maturity date. They give you your money back and stop paying interest. Of course they would only do this when interest rates are falling and they can borrow money more cheaply elsewhere. As you now know, when rates fall the value of your bond goes up. But if it gets called, poof! There goes your nice gain.

All of these risks are nicely mitigated simply by owning a broad-based bond index fund. That’s why VBTLX is our choice.

Vanguard has several funds devoted to municipal bonds, including several focused on specific states. Anyone interested can check them out on www.vanguard.com

Put all your eggs in one basket and forget about it.

The great irony of investing is that the more you watch and fiddle with your holdings the less well you are likely to do. Fill your basket, add as much as you can along the way and ignore it the rest of the time. You’ll likely wake up rich.

Here’s the basket: VTSAX. No surprise here if you’ve been paying attention so far. This is the Total Stock Market Index Fund that holds virtually every publicly traded company in the U.S. That means you’ll be owning a part of about 3,700 businesses across the country, making it a very big and diverse basket. T...

As an aside, there are studies that indicate holding a 10-25% position in bonds with 75-90% stocks will actually very slightly outperform a position holding 100% stocks. It is also slightly less volatile. If you want to go that route and take on the slightly more complicated process of periodically rebalancing to maintain the allocation, you’ll get no argument from me.

Could it really be this easy? Yep. I started investing in 1975. At the time VTSAX had yet to be created, but over the 40 years from January 1975 until January 2015, the S&P 500 index produced an annualized growth rate of 11.9%.1 Just $2,400 a year ($200 per month) invested and left to ride would have grown to $1,515,5422 by 2015. Over that same period, a one time lump sum investment of $10,000 would have become $897,9052 This despite all the panics and collapses and recessions and disasters we’ve endured during these last 40 years.

~75% Stocks: VTSAX (Vanguard Total Stock Market Index Fund). Still our core holding for all the reasons we’ve discussed. ~20% Bonds: VBTLX (Vanguard Total Bond Market Index Fund). Bonds provide some income, tend to smooth out the rough ride of stocks and are a deflation hedge. ~5% Cash: We hold ours in our local bank.

With that said, age does begin to limit your options as it advances. Age discrimination is a very real thing, especially in the corporate world. As you get older, you may not have all the same options readily available as you had in your youth. If your life journey involves stepping away from highly paid work occasionally, you’ll do well to consider this. Further, as you age you steadily have less time for the compounding growth of your investments to work and to recover from market plunges. Both these considerations will influence your risk profile and you might well want to consider adding bonds a bit earlier if that’s the case.

With separate funds, I can keep my bonds in my tax-advantaged bucket, protecting the dividends and interest from taxes. If you decide to own TRFs, they too are best held in a tax-advantaged bucket.

opportunity to shift money tax-free over time from your Traditional IRA to a Roth IRA (this is sometimes called a Roth Conversion Ladder), thus further avoiding taxes when you withdraw and spend it. These are well worth considering if your situation allows for them. You can find details in these posts: From Go Curry Cracker: Never Pay Taxes Again: http://www.gocurrycracker.com/never-pay-taxes-again/ GCC vs. The RMD: http://www.gocurrycracker.com/gcc-vs-rmd/ From The Mad Fientist: Early Retirement Strategies and Roth Conversion: http://jlcollinsnh.com/2013/12/05/stocks-part-xx-early-retirement-withdrawal-strategies-and-roth-conversion-ladders-from-a-mad-fientist/ Traditional IRA vs. Roth IRA - The Final Battle: http://www.madfientist.com/traditional-ira-vs-roth-ira/ Retire even earlier without earning more or spending less: http://www.madfientist.com/retire-even-earlier/

IRAs are buckets you hold on your own in addition to and separate from any employer-sponsored 401(k)-type plans you may have. You have complete control in selecting the investment company and the investments for your IRA. This means you also control costs and can avoid those companies and investments that charge excessive fees. Mine are all with Vanguard.

With all this in mind, here is my basic hierarchy for deploying investment money: Fund 401(k)-type plans to the full employer match, if any. Fully fund a Roth if your income is low enough that you are paying little or no income tax. Once your income tax rate rises, fully fund a deductible IRA rather than the Roth. Keep the Roth you started and just let it grow. Finish funding the 401(k)-type plan to the max. Consider funding a non-deductible IRA if your income is such that you cannot contribute to a deductible IRA or Roth IRA. Fund your taxable account with any money left.

Except for the Roth IRA, all of the tax-advantaged buckets discussed in Chapter 19 have RMDs (required minimum distributions) as part of the deal and these begin at age 70 1/2. Basically this is the Feds saying “OK. We’ve been patient but now, pay us our money!” Fair enough. But for the readers of this book who are building wealth over the decades, there may well be a very large amount of money in these accounts when the time comes. Pulling it out in the required amounts on the government time schedule could easily push us into the very highest tax brackets. Make no mistake, once you reach 70 1/2 these withdrawals from your IRAs, 401(k)s, 403(b)s and the like are no longer optional. Fail to take your full distribution and you’ll be hit with a 50% penalty. Fail to withdraw enough and the government will take 50% of however much your shortfall is. That’s right, they will take half of your money. This is not something you want to overlook.

As we sit back and ponder all this, an interesting option occurs. Suppose we fully funded our HSA and invested the money in low-cost index funds? Then we’d pay our actual medical expenses out-of-pocket, carefully saving our receipts, while letting the HSA grow and compound tax-free over the decades. In effect, we’d have a Roth IRA in the sense that withdrawals are tax-free and a regular IRA in the sense that we get to deduct our contributions to it. The best of both worlds. If we ever needed the money for medical expenses, it would still be there. But if not, it would grow tax-free to a potentially much larger amount. When we were ready, we would pull out our receipts and reimburse ourselves tax-free from our HSA, leaving any balance for future use. Should we be fortunate enough to remain healthy, after age 65 we would be able to take it out to spend as we please, just as with our IRA and 401(k) accounts, paying only the taxes then due. And how about those nasty RMDs discussed in the last chapter? Well, so far the law has been silent on this point. It could go either way. Keep your fingers crossed.

When you dollar cost average into an investment you take your chunk of money, divide it into equal parts and then invest those parts at specific times over an extended period of time.

Assuming you were paying attention while reading Parts I & II, you know that the market always goes up but that it is a wild ride. The other thing you know is that it goes up more often than it goes down. Consider that between 1970 and 2013, the market was up 33 out of 43 years. That’s 77% of the time.

(shorting is a way to sell stock you don’t own on a bet it will decline in price)

You don’t have to have read far in the retirement literature to have come across the “4% rule.” Unlike most common advice, this one holds up to our beady-eyed scrutiny pretty well, even though it is really very little understood.

How much you can withdraw and not run out of money once you're in the spending phase.

In summary: Withdrawing 3% or less annually is as near a sure bet as anything in this life can be. Stray much further out than 7% and your future will include dining on dog food. Stocks are critical to a portfolio’s survival rate. If you absolutely, positively want a sure thing and your yearly inflation raises, keep your withdrawal rate under 4%. And hold 75% stocks/25% bonds. Give up those yearly inflation raises and you can push up towards 6% with a 50% stock/50% bond mix. In fact, the authors of the study suggest you can withdraw up to 7% as long as you remain alert and flexible. That is, if the market takes a huge dive, cut back on your withdrawals and spending until it recovers.

I would not set up a 4% annual withdrawal plan and forget about it.

Once you reach age 62, you can begin receiving Social Security. The catch is, the sooner you start, the smaller your checks. The longer you delay (up until age 70), the bigger the checks. Of course, the longer you delay the fewer the years you’ll be collecting.