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

by J.L. Collins

When you can live on 4% of your investments per year, you are financially independent.

One of my very few regrets is that I spent far too much time worrying about how things might work out. It’s a huge waste, but it is a bit hardwired into me. Don’t do it.

If you intend to achieve financial freedom, you are going to have to think differently. It starts by recognizing that debt should not be considered normal. It should be recognized as the vicious, pernicious destroyer of wealth-building potential it truly is. It has no place in your financial life.

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. Remember, the more house you buy, the greater its cost. Not just in higher mortgage payments, but also in higher real estate taxes, insurance, utilities, maintenance and repairs, landscaping, remodeling, furnishing and opportunity costs on all the money tied up as you build equity. To name a few.

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. Here’s the simple formula: Spend less than you earn—invest the surplus—avoid debt

The world is filled with athletes, performers, lawyers, doctors, business executives and the like who have been showered with money that all too often immediately flowed right off of them and into the pockets of others. In a sense, they never really had a chance. They never learned how to think about money.

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.

The market is the most powerful wealth-building tool of all time. The market always goes up and it is always a wild and rocky ride along the way. Since we can’t predict these swings, we need to toughen up mentally and ride them out. I want my money working as hard as possible, as soon as possible.

The curse of fear is that it will drive you to panic and sell when you should be holding. The market is volatile. Crashes, pullbacks and corrections are all absolutely normal. None of them are the end of the world, and none are even the end of the market’s relentless rise. They are all, each and every one, expected parts of the process.

Everybody makes money when the market is rising. But what determines whether it will make you wealthy or leave you bleeding on the side of the road is what you do during the times it is collapsing.

The market is the single best performing investment class over time, bar none.

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.

“We’ve stayed the course, with a side-dish of panic.” It’s a great line, and staying the course is always served with a side dish of panic. That’s why ya gotta be tough.

Care to guess how many of the original 12 are still in it? Just one. General Electric. In fact, most of today’s 30 companies didn’t exist when Mr. Dow originally crafted his list. Most of the originals have come and gone or morphed into something new. This is a key point: the market is not stagnant. Companies routinely fade away and are replaced with new blood.

Understand too, that what the media wants from these commentators is drama. Nobody is going to sit glued to their TV while some rational person talks about long-term investing. But get somebody to promise the Dow is going to 20,000 by year’s end or, better yet, is on the verge of careening into the abyss, and brother you’ve got ratings!

Ironically, a crash at the beginning of your investing life is a gift. In fact, any pullback in stock prices is a gift while you are in the process of accumulating your wealth. It allows you to buy more shares for your dollars, on sale if you will.

There is no risk-free investment. Once you begin to accumulate wealth, risk is a fact of life. You can’t avoid it, you only get to choose what kind. Don’t let anyone tell you differently. If you bury your cash in the backyard (or in an FDIC insured bank account at today’s near zero interest rates) and dig it up 20 years from now, you’ll still have the same amount of money. But even modest inflation levels will have drastically reduced its spending power. If you invest in stocks, you’ll likely outpace inflation and build wealth but you’ll have to endure a volatile ride.

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. You might be planning to retire early. You might be worried about your job. You might be taking a sabbatical. You might be accepting a lower paid position to follow a dream. You might be launching a new business. You might be returning to the workforce after several years of retirement. Your life stages may well shift several times over the course of your life. Your investment stage can easily shift with them.

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.

The harsh truth is, I can’t pick winning individual stocks and you can’t either. Nor can the vast majority who claim they can. It is extraordinarily difficult, expensive and a fool’s errand. Having the humility to accept this will do wonders for your ability to accumulate wealth.

Today’s stars are tomorrow’s wrecks. Today’s fallen are tomorrow’s exciting turnarounds.

Professional money managers are measured against how well they do against this return. As we’ve seen, in any given year most underperform their target index. Indeed, over periods of 15 to 30 years, the index will outperform 82% to 99% of actively managed funds. This means just buying a total stock market index fund like VTSAX guarantees you’ll be in the top performance tier. Year after year. Not bad for accepting “average.” I can live (and prosper) with that kind of average.

Paying fund and/or advisor fees of 1-2 percent seems low, especially in a good year. But make no mistake, these annual fees are a devil’s ball and chain on your wealth. As a point of reference, the average mutual fund ER (expense ratio: the fee funds charge investors) is ~1.25%. The ER for VTSAX is .05%. As Bogle says, performance comes and goes but expenses are always there, year after year. After year. Compounded over time the amount lost is breathtaking.

Bonds are in our portfolio to provide a deflation hedge. Deflation is one of the two big macro risks to your money. Inflation is the other and we hedge against that with our stocks. You’ll recall from earlier that deflation occurs when the price of goods spirals downward and inflation occurs when they soar. Yin and yang.

When you buy stock you are buying a part ownership in a company. When you buy bonds you are loaning money to a company or government agency.

If you are going to hold bonds, holding them in an index fund is the way to go. Very few individual investors opt to buy individual bonds, with U.S. treasuries being the main exception, along with bank CDs which act like bonds.

So default is the first risk associated with bonds. To help investors evaluate the risk in any company or government bond, various rating agencies evaluate their creditworthiness. They use a scale ranging from AAA on down to D, kinda like high school. The lower the rating, the higher the risk. The higher the risk, the harder it is to find people to buy your bonds. The harder it is to find people to buy your bonds, the more interest you have to pay to attract them. Investors expect to be paid more interest when they accept more risk.

So default risk is also the first factor determining how much interest your bond will pay you. As a buyer of bonds, the more risk you are willing to accept the higher the interest you’ll receive.

When interest rates rise, bond prices fall. When interest rates fall, bond prices rise. In either case, if you hold a bond to the end of its term you will, barring default, get exactly what you paid for it.

Inflation is the biggest risk to your bonds. As we’ve discussed, inflation occurs when the cost of goods is rising. When you lend your money by buying bonds, during periods of inflation when you get it back it will buy less stuff. Your money is worth less. A big factor in determining the interest rate paid on a bond is the anticipated inflation rate.

Since some inflation is almost always present in a healthy economy, long-term bonds are sure to be affected. That’s a key reason they typically pay more interest.

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

Here’s what your kindly old Uncle Jim says: 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. The fact that it is a low-cost index fund keeps more of your money working for you.

Because VTSAX is an index fund, we don’t even have to worry about which companies will succeed and which will fail. As we’ve seen, it is ‘self-cleansing.’ The failures fall away and the winners can grow endlessly.

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.

For instance, you might own VTSAX in both an IRA and in a taxable account. Should you need to sell to rebalance that year, sell in the taxable account to capture the loss. You can deduct it against any other gain you happen to have, including any capital gain distributions.

If it does—and you feel the need for even more international exposure than that imbedded in VTSAX—our friends at Vanguard have some excellent options. Here are three I suggest: VFWAX: FTSE all-World ex-U.S. Index Fund (expense ratio .13%) VTIAX: Total International Stock Index Fund (expense ratio .12%)

If you prefer to keep things as simple as possible, at a bit higher cost, you might look at: VTWSX: Total World Stock Index Fund (expense ratio .25%)

Here’s what you are looking for: A low-cost index fund. For tax-advantaged funds you’ll be holding for decades, I slightly prefer a total stock market index fund but an S&P 500 index fund is just fine. You can also look for a total bond market index fund if your needs or preferences call for it. Most plans will also offer these. TRFs (Target Retirement Funds) are frequently offered in 401(k) plans and these can be an excellent choice. But look closely at the fees. They are always higher than those for index funds, sometimes by a lot. For instance, the TRFs from Vanguard have expense ratios ranging from .14% to .16%, as compared to .05% for VTSAX. Those from other firms can run 5-6x higher.

Advisors are expensive at best and will rob you at worst. Google Bernie Madoff. If you choose to seek advice, seek it cautiously and never give up control. It’s your money and no one will care for it better than you. But many will try hard to make it theirs. Don’t let it happen. When I say investment advisors, I am also referring to money managers, investment managers, brokers, insurance salespeople (who often masquerade as financial planners) and the like. Any and all who make their money managing yours.

Suppose you have a nest egg of $100,000. That’s about the minimum needed to interest an advisor. Let’s further suppose you invest it for 20 years and earn 11.9% per year which as we’ve seen is the average annual return of the past 40 years (January 1975 - January 2015)1. You end up with $947,549.3 Not bad. Now suppose you give up 2% of these annual gains to a management fee. Your net return is now 9.9% and after 20 years that yields $660,623.3 That’s a whopping $286,926 less. Yikes! You not only give up the 2% each year, you give up all the money that money would have earned compounding for you over the 20 year period. Let me hammer this point home—it’s a very big deal.

If you are a novice investor you have two choices: You can learn to pick an advisor. You can learn to pick your investments. Both require effort and time. But the second not only provides better results, it is the easier and less expensive path.

While no one ever has, if someone were to ask me what single thing has most impeded the growth of my personal wealth the answer would be my stubborn rejection of the concept of indexing for an embarrassingly long number of years.

Even Warren Buffett, perhaps history’s most successful stock-picker, has gone on record as recommending indexing, specifically for his wife’s trust once he has passed.

“My advice … could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers.”

The more I see a charity advertising, the less likely I am to believe they are focused on delivering my cash to those they claim to serve.

As individuals we only have one obligation to society: To ensure we, and our children, are not a burden to others. The rest is our personal choice. Make your own and make the world a far more interesting place.

Houses are not investments, they are expensive indulgences. Buy one only when you can easily afford it and if it provides the lifestyle change you want.