I love putting my money to work. I prioritize buying assets over possessions that lose their value over time, like expensive cars or expensive clothing. And, luckily, Kubo Queen feels the same way too. So, here at the Kubo, we do our best to make sure the money we earn is put to good use. You may not know this, but while we were still trying to pay off my student loans, Kubo Queen and I were also investing some of our money. Now that my students loans are paid off, we will be able to invest even more money for our future. So I thought that this was the perfect time to share our investing habits with the hope of showing you how easy investing truly is (I mean, if we were able to learn it, then so can you). And, hopefully, it will encourage you to start investing for your future too.
After reading and learning about the topic of investing, Kubo Queen and I have come to the conclusion that buying stocks and bonds is the simplest and most effective way of investing. And so that is what we do. We direct a significant percentage of our income towards buying stocks and bonds regularly. But you might be wondering what stocks and bonds are in the first place. So let’s briefly go over them.
To put it simply, a stock is a piece (or a share) of a company. Companies sell (or issue) stocks in order to raise money to fund their projects and operations. In return, buyers of the stocks are entitled to a part of the company’s assets and earnings. In other words, they become owners of that company, and their ownership is in proportion to the amount of stocks they bought (and, hence, own). In most cases, when you own a company’s stock, the company will give you a piece of its profits regularly. And the amount of payment you receive is in proportion to the amount of shares you own with respect to the amount of money (from its profits) the company decides to give away. This payment is also known as a dividend. You can choose to spend the money you earn from the dividend payments or choose to reinvest it instead by using it to buy more shares (creating a compounding effect). And this is one of the two main ways you earn money from buying stocks.
Not all companies pay dividends, however. In fact, as of now, Amazon and Google are among those that do not pay dividends to their investors. Fortunately, you can still earn money from buying their stocks through a thing called appreciation. This is a simple phenomenon. Basically, you buy some shares of a company at the market for some price. You hold them for a while. And then you sell them at the market at some point in the future when their value has gone up (e.g., when their value has doubled or quadrupled). Once they have been bought from you, you will effectively make a profit since you have just sold them at a higher price than you bought them for. That, in essence, is how you make money through appreciation. However, note that the companies that do not pay dividends now may choose to pay dividends later. So you can potentially earn money from both the dividends and the appreciation in the future…
Now let’s talk about bonds. Basically, a bond represents a loan given by an investor to a borrower. The borrowers, in this case, are usually sovereign countries (e.g., the United States, China, Great Britain, Germany, etc.), municipalities, states, and even companies. Similar to stocks, bonds are used to raise money to fund an entity’s projects and operations. By loaning money, the investor will make a profit according to the bond’s interest rate and maturity date. For example, a 30-year U.S. Treasury Bond is currently paying around 2.71% in interest. So this means that if you buy $10,000 of 30-year U.S. Treasury Bonds, then you will receive $271 annually from the United States government for 30 years. And once the 30 years is up, you will then be paid back the $10,000 you loaned.
Stocks and bonds have two major differences in terms of their returns on investment. Stocks average a higher rate of return, about 7% annually (after inflation) for US stocks, but they are riskier in that the short-term returns vary widely. For example, when the stock market is down you may temporarily lose money on the stocks you previously bought. But in the long run, historically, the returns have always evened out to about 7% [1]. Bonds are less risky, because the interest you earn is guaranteed by the issuing country or entity. However, they typically have lower returns on investment, at less than 3% for US bonds today (and that’s before inflation, so the real return is even worse).
Now that you have an idea of what stocks and bonds are, and how you can make money from investing in them, you might be wondering which stocks and which bonds you should buy if you were to start investing. The great news is that a lot of very smart and very talented people have been studying this question for a long time. And they have found, from decades of data, that the most efficient and effective strategy is to buy all of them and to hold on to them for a long time [2]. ALL OF THEM??? What does this mean and how is this done? Well, this is where index funds come in.
An index fund is a mutual fund that tracks and mimics a major financial market index (e.g., the S&P 500, the Wilshire 5000, or the Bloomberg Barclays US Aggregate Bond Index). Stocks (or bonds) are bought in ratios according to their weight on the market, usually based on their market capitalization, to match the composition of the index it’s tracking. The stocks (or bonds) effectively make up the portfolio of the index fund. To give a concrete example of how this works, let’s consider Vanguard’s VFIAX. VFIAX tracks the S&P 500 index fund, which is an index weighted based on market capitalization. It is composed of the 500 largest American companies in ratios according to their market capitalization. The index fund, VFIAX, buys stocks of those 500 companies according to their ratios in the S&P 500 index. And this is where investors like you and I come in. Ordinary people who wish to invest in a broad range of companies can buy shares of the index fund, instead of directly investing in the underlying stocks and bonds. This let’s you have diverse investments by simply buying shares of one fund, such as VFIAX.
Investing in passively-managed, low-cost, and broadly-diversified index funds has been shown to be the most efficient and most effective form of investing in the stock and bond markets for people like you and I. The alternative is to manage many different investments in various companies yourself, or to pay someone else to do this for you. By choosing to invest in an index fund instead, you will come out ahead, in terms of real returns on your investments, because you are not paying some hot-shot financial advisor some absurd amount of management fees to manage the portfolio for you. In other words, you will receive more of the money that your investments returned instead of seeing a big portion of it get eaten by higher management fees. And this extra money can be used to reinvest in the index fund creating a larger compounding principal year after year.
It also saves you the work of deciding which stocks and bonds to buy since the index is already buying all of them in appropriate ratios [3]. For example, Vanguard’s VTSAX indexes nearly 100% of all the tradable stocks in the US market. This means that, if you invest in VTSAX, you’re not just hedging your bets on the success of 10, 40, or 80 American companies representing only a tiny fraction of the US economy, but on the success of nearly the entire US economy — which has been the largest and most successful economy in the world for decades with no signs of slowing down… Basically, the US economy (or its GDP) has been growing, on average, 2.9% annually since WWII [4]. So if you invest your money in the entire economy you are very likely to see your investment grow.
So how does the Kubo invest its money? It’s simple, we use a significant portion of our income to buy shares in these index funds:
STOCKS
- Total US Stock Market Index Fund (VITPX and VTSMX)
- S&P 500 Index Fund (FXAIX)
- Total International Stock Index Fund (VGTSX)
BONDS
- Total US Bond Market Index Fund (VBMFX)
- Northern Trust US Aggregate Bond Index Fund
- Total International Bond Index Fund (VTIBX)
Note that there are some redundancies in the indexes we invest in (for example, VITPX and VTSMX are effectively the same indexes), but this is because Kubo Queen and I have our own accounts. What I would like you to note is that, although we invest in international stocks and bonds, we highly favor American stocks and bonds. To give you some numbers, our portfolio is roughly composed of 71.7% American stocks and only 19.6% of International stocks [5]. Similarly, we own 7.1% American bonds and only 1.6% of International bonds [5]. There are good reasons for this, but mainly it’s because historical data shows that American stocks outperform international stocks and that American bonds are among the highest quality bonds in the world.
Another thing to note is that our portfolio is made up of roughly 91.3% stocks and 8.7% bonds. Our ideal allocation at this point in our lives is 90/10, meaning 90% stocks and 10% bonds. Again, there are many reasons why we decided that this particular allocation is the best for us at the moment. But, basically, it’s because we are both still young and, thus, have a longer time horizon for investing versus those who are already in their 50s. So having a larger amount of our money in the best performing (but riskier) investments makes more sense to us than putting them in mediocre performing (but more stable) investments. In other words, we have room to be a little riskier and aggressive with our investments in the hope that we will see greater returns on them over the long run. However, the ideal allocation will surely change as we get older and closer to retirement.
So there you have it. This is pretty much how we invest our money. If you would like to start investing, then I suggest that you start with opening up a Vanguard IRA account and invest in VTSAX and/or VBTLX. If you do not have enough money to meet the minimum required investment for those funds, don’t worry about it, you can invest in one of the funds here instead with only a $1,000 minimum. Kubo Queen and I like Vanguard very much since it’s the only investment company that is mutually structured — its clients are its owners.
[1] See John Bogle’s Common Sense on Mutual Funds
[2] See John Bogle’s Common Sense on Mutual Funds; Burton Malkiel’s A Random Walk Down Wall Street; and Warren Buffett’s opinion on indexing
[3] It buys stocks (or bonds) according to the index its tracking
[4] See Thomas Piketty’s Capital in the Twenty-First Century
[5] Generally, Total International Stock (or Bond) Index Funds heavily focuses on mature and emerging economies (e.g., western Europe, China, Japan, Brazil, Russia, etc.)
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