6

Context:

  • €13000 banked on a 1% savings account.
  • €1700 banked on a payment account.
  • €1450 monthly income (after taxes).
  • ~€400 monthly costs, and probably another €200-400 in incidental expenditures (food, games, clothing)
  • I'm 21 years old.
  • I have no debts.

I'm left with a good €650-€850 that I put in my savings on a monthly basis.

The trend in my life so far has been that money comes into my bank account and rarely leaves it. Monthly expenditures are €300 for rent, €8 for phone internet, and a good €100 or so in insurance. I still live with my parents. This is not likely to change for the next few years (5).

I want to start putting my money to good use. It's doing nothing at the moment, and I feel I'm missing out. I recently discovered "Mr Money Mustache" and his "early retirement plan": Invest your money, watch it grow with 2 to 4% after inflation via low transaction cost index funds, and retire early.

I like the idea of that. Not so much the idea of "quit your job at 40 and then vacation all day long" but more the idea of "quit your job at 40 and then work in the way you want". That is, having investments compound so much that you can live off the dividends.

Perhaps I can't use the money I will earn to retire early, because my parents will kick me out and make me buy my own home when they realize I've got 50k stashed away in a few years. This doesn't take away from my goal: To allow my savings to keep up with, or even beat inflation, so that I may use it for a big purchase or financial independance in 15/20/25/30 years.

I've been doing some research, but I'm getting antsy. My parents don't trust the stock market ("You'll have more luck playing the lottery"). Yet I can't just leave my money in savings accounts; it will lose to inflation. It's not much right now, but losing purchase power due to leaving my money in the bank feels wrong to me.

I also feel that even if I screw up right now, I will blow €10000. I can earn this back in a year. But for me to lose that in an index fund... wouldn't the whole economy have to collapse so badly half the world is homeless?

I'm planning on buying something related to Vanguard; but if this is a bad option for an European, I'd like to know. I want to split my investments between stocks and bonds and a small private project.

With this, I have a few questions:


  • If I invest in index funds or other long term stocks that pay dividend which I reinvest, they don't need to be worth more per share for me to make a profit, right? That is, if I sell part of the stocks, it's GOOD if they're worth more than I bought them at, but the real money comes from the QUANTITY of stocks that you get by reinvesting your dividends, right?

  • Can I invest "small amounts" (part of paycheck) into index funds on a monthly basis, like €500, without taking major "transaction fees"? (Likely to be index fund specific... general answers or specific answers using popular stocks welcomed).

  • Is this plan market-crash proof? My parents keep saying that "Look at 2008 and think about what such a thing would do to your plan", and I just see that it will be a setback, but ultimately irrelevant, unless it happens when I need the money. And even then I'm wondering whether I'll really need ALL of my money in one go. Doesn't the index fund go back up eventually? Does a crash even matter if you plan on holding stocks for 10 or more years?

  • Does what I'm planning have similarities with some financial concept or product (to allow me to research better by looking at the risks of that concept/product)? Maybe like a mortgage investment plan without the bank eating your money in between?

These boil down to my base question:

Can I make my savings keep in check with, or beat, inflation over a long time period via index funds?

If no;

Is what I'm planning at least better than stuffing all my money in savings that have 1% interest?

  • I STRONGLY recommend reading JL Collins stock series blog posts, which is also recommended by Mr. Money Mustache. He addresses concerns and risks of investing in the stock market and how and why you should make that investment using low cost index funds. The only problem with his advice is that it is US centric, so I'm not sure what options you have that are equivalent. – David G Jan 8 '15 at 17:39
8

Question 2

Some financial institutions can provide a way to invest small amounts with low or no cost fees over a period of time (like monthly, weekly, etc). For instance, a few brokerages have a way to buy specific ETFs for no cost (outside of the total expense ratio).

Question 3

When someone says that investing is like buying a lottery ticket, they are comparing an event that almost always has at least a 99.9% of no return (large winnings) to an event that has much better odds. Even if I randomly pick a stock in the S&P 500 and solely invest in it, over the course of a given year, I do not face a 99.9% chance of losing everything.

So comparing the stock market to a lottery, unless a specific lottery has much better odds (keep in mind that some of these jackpots have a 99.9999999% of no return) is not the same. Unfortunately, nothing truly safe exists - risk may mutate, but it's always present; instead, the probability of something being safe and (or) generating a return may be true for a given period of time, while in another given period of time, may become untrue.

One may argue that holding cash is safer than buying an index fund (or stock, ETF, mutual fund, etc), and financially that may be true over a given period of time (for instance, the USD beat the SPY for the year of 2008). Benjamin Franklin, per a biography I'm reading, argued that the stock market was superior to gold (from the context, it sounds like the cash of his day) because of what the stock market represents: essentially you're betting on the economic output of workers. It's like saying, in an example using oil, that I believe that even though oil becomes a rare resource in the long run, human workers will find an alternative to oil and will lead to better living standards for all of us.

Do civilizations like the Mongolian, Roman, and Ottoman empires collapse? Yes, and would holding the market in those days fail? Yes. But cash and gold might be useless too because we would still need someone to exchange goods with and we would need to have the correct resources to do so (if everyone in a city owns gold, gold has little value). The only "safe bet" in those days would be farming skill, land, crops and (or) livestock because even without trading, one could still provide some basic necessities.

  • 3
    Q3: Personally, I believe there are risks involved, but they are not very big. Yes, I can lose book value of 50% in a really bad crash, but why would the market not go back up after that? It's just a case of not selling the investments as long as they're of low value - and for that, one spreads his assets, right? To me, the risk is a moot point, as long as the idea of "I will break even or be at a profit if the market pulls back up later" holds, precisely because I don't see civilization failing. I appreciate your illustration in what a big market crash represents, though. – Pimgd Jan 7 '15 at 14:21
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    Right. The Vanguard index fund that tracks the S&P 500 recovered from the 2008 "crash" in 3.5 years. And, it continued to pay dividends throughout that entire period. I am retired and live on dividends and continued to do so throughout the entire period. In fact, my dividend income has increased every year. There are many index funds that hold only stocks that have increased their dividends every year. – ScottMcP-MVP Jan 7 '15 at 15:29
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    The lottery is a stellar example of how to analyze risk:reward ratio. If you want to get in the mindset of an investor, try watching professional poker players (like twitch.tv/jcarverpoker who explains his thought process well). You hear things like "I have to spend 400 to win a 1600 pot. Will I win this more than 20% of the time? I think in this position, given what I've seen, I will." It's not gut feeling, it's market analysis and statistics. Run the numbers on Lotto-649. "I need to spend $5 to win $50 million. But my chance of winning is 1 in 601,304,088." Fold that every time. – corsiKa Jan 7 '15 at 18:01
  • (continued) you can use that same logic for a mutual fund or an index. Estimate the chance it's going to go down. Run the numbers. Just plug in "I risk ____ amount to win ____ amount with ____% chance to lose my money." Simple. I had a friend do a stock competition in university where they were given a million dollars (real money!) and had to compete against other schools. It wasn't the team who had the most money at the end who won: it was the team with the most money weighed against how risky it was. Mediocre return from super low risk was "better" than good money from high risk. – corsiKa Jan 7 '15 at 18:10
3

While nothing is guaranteed - any stock market or country could collapse tomorrow - if you have a fairly long window (15+ years is certainly long), ETFs are likely to earn you well above inflation. Looking at long term ETFs, you typically see close to 10% annual growth over almost any ten year period in the US, and while I don't know European indexes, they're probably well above inflation at least.

The downside of ETFs is that your money is somewhat less liquid than in a savings account, and any given year you might not earn anything - you easily could lose money in a particular year. As such, you shouldn't have money in ETFs that you expect to use in the next few months or year or even a few years, perhaps.

But as long as you're willing to play the long game - ie, invest in ETF, don't touch it for 15 years except to reinvest the dividends - as long as you go with someone like Vanguard, and use a very low expense ratio fund (mine are 0.06% and 0.10%, I believe), you are likely in the long term to come out ahead. You can diversify your holdings - hold 10% to 20% in bond funds, for example - if you're concerned about risk; look at how some of the "Target" retirement funds allocate their investments to see how diversification can work [Target retirement funds assume high risk tolerance far out and then as the age grows the risk tolerance drops; don't invest in them, but it can be a good example of how to do it.]

All of this does require a tolerance of risk, though, and you have to be able to not touch your funds even if they go down - studies have repeatedly shown that trying to time the market is a net loss for most people, and the best thing you can do when your (diverse) investments go down is stay neutral (talking about large funds here and not individual stocks).

I think this answers 3 and 4.

For 1, share price AND quantity matter (assuming no splits). This depends somewhat on the fund; but at minimum, funds must dividend to you what they receive as dividends. There are Dividend focused ETFs, which are an interesting topic in themselves; but a regular ETF doesn't usually have all that large of dividends. For more information, investopedia has an article on the subject. Note that there are also capital gains distributions, which are typically distributed to help offset capital gains taxes that may occur from time to time with an ETF. Those aren't really returns - you may have to hand most or all over to the IRS - so don't consider distributions the same way.

The share price tracks the total net asset value of the fund divided by the number of shares (roughly, assuming no supply/demand split). This should go up as the stocks the ETF owns go up; overall, this is (for non-dividend ETFs) more often the larger volatility both up and down.

For Vanguard's S&P500 ETF which you can see here, there were about $3.50 in dividends over 2014, which works out to about a 2% return ($185-$190 share price). On the other hand, the share price went from around $168 at the beginning of 2014 to $190 at the end of 2014, for a return of 13%. That was during a 'good' year for the market, of course; there will be years where you get 2-3% in dividends and lose money; in 2011 it opened at 116 and closed the year at 115 (I don't have the dividend for that year; certainly lower than 3.5% I'd think, but likely nonzero.)

The one caveat here is that you do have stock splits, where they cut the price (say) in half and give you double the shares. That of course is revenue neutral - you have the same value the day after the split as before, net of market movements.

All of this is good from a tax point of view, by the way; changes in price don't hit you until you sell the stock/fund (unless the fund has some capital gains), while dividends and distributions do. ETFs are seen as 'tax-friendly' for this reason.

For 2, Vanguard is pretty good about this (in the US); I wouldn't necessarily invest monthly, but quarterly shouldn't be a problem. Just pay attention to the fees and figure out what the optimal frequency is (ie, assuming 10% return, what is your break even point). You would want to have some liquid assets anyway, so allow that liquid amount to rise over the quarter, then invest what you don't immediately see a need to use.

You can see here Vanguard in the US has no fees for buying shares, but has a minimum of one share; so if you're buying their S&P500 (VOO), you'd need to wait until you had $200 or so to invest in order to invest additional funds.

  • With Q1 I meant "In the event of a sale, it doesn't matter if the stock price is below, but near, its original price that I bought it at" in order to make a profit? I guess its just maths, but I'm trying to disprove the assumption "I can only gain if I sell at a higher price than I bought at". – Pimgd Jan 7 '15 at 16:10
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    @Pimgd Ah, now I understand, will edit. – Joe Jan 7 '15 at 16:17
  • @Pimgd Okay, added some additional detail. The specifics here depend on exactly what funds you buy, but overall the price of the fund does matter (assuming you take splits into account) typically more so than dividends. – Joe Jan 7 '15 at 16:41
2

If I invest in index funds or other long term stocks that pay dividend which I reinvest, they don't need to be worth more per share for me to make a profit, right? That is, if I sell part of the stocks, it's GOOD if they're worth more than I bought them at, but the real money comes from the QUANTITY of stocks that you get by reinvesting your dividends, right?

I would say it is more the other way around. It is nice to get dividends and reinvest them, but overall the main gain comes from the stocks going up in value.

The idea with index funds, however, is that you don't rely on any particular stock going up in value; instead you just rely on the aggregate of all the funds in the index going up. By buying lots of stocks bundled in an index fund, you avoid being too reliant on any one company's performance.

Can I invest "small amounts" (part of paycheck) into index funds on a monthly basis, like €500, without taking major "transaction fees"? (Likely to be index fund specific... general answers or specific answers using popular stocks welcomed).

Yes, you can. At least in the US, whether you can do this automatically from your paycheck depends on whether you employer has that set up. I don't know that work in the Netherlands. However, at the least, you can almost certainly set up an auto-invest program that takes $X out of your bank account every month and buys shares of some index fund(s).

Is this plan market-crash proof? My parents keep saying that "Look at 2008 and think about what such a thing would do to your plan", and I just see that it will be a setback, but ultimately irrelevant, unless it happens when I need the money. And even then I'm wondering whether I'll really need ALL of my money in one go. Doesn't the index fund go back up eventually? Does a crash even matter if you plan on holding stocks for 10 or more years?

Crashes always matter, because as you say, there's always the possibility that the crash will occur at a time you need the money. In general, it is historically true that the market recovers after crashes, so yes, if you have the financial and psychological fortitude to not pull your money out during the crash, and to ride it out, your net worth will probably go back up after a rough interlude. No one can predict the future, so it's possible for some unprecedented crisis to cause an unprecedented crash. However, the interconnectedness of stock markets and financial systems around the world is now so great that, were such a no-return crash to occur, it would probably be accompanied by the total collapse of the whole economic system. In other words, if the stock market dies suddenly once and for all, the entire way of life of "developed countries" will probably die with it. As long as you live in such a society, you can't really avoid "gambling" that it will continue to exist, so gambling on there not being a cataclysmic market crash isn't much more of a gamble.

Does what I'm planning have similarities with some financial concept or product (to allow me to research better by looking at the risks of that concept/product)? Maybe like a mortgage investment plan without the bank eating your money in between?

I'm not sure what you mean by "what you're planning". The main financial products relevant to what you're describing are index funds (which you already mentioned) and index ETFs (which are basically similar with regard to the questions you're asking here). As far as concepts, the philosophy of buying low-fee index funds, holding them for a long time, and not selling during crashes, is essentially that espoused by Jack Bogle (not quite the inventor of the index fund, but more or less its spiritual father) and the community of "Bogleheads" that has formed around his ideas. There is a Bogleheads wiki with lots of information about the details of this approach to investing. If this strategy appeals to you, you may find it useful to read through some of the pages on that site.

  • Hmm... So if I profit from the value of the stocks, how do I know that it will increase over a long time period? Or is the idea as such that with dollar cost averaging, your actual average is lower, and when the price does go up to its original value, you gain that much more? Your answer left be wondering about how index funds can attain the long term profits that @Joe describes in his answer. – Pimgd Jan 8 '15 at 7:20
  • @Pimgd: The assumption is that a broad market index fund will increase as long as the overall economy is healthy. – BrenBarn Jan 8 '15 at 7:26
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For your base question, yes. (Barring some major collapse-of-civilization event, but in that case you're screwed anyway :-)) On the individual points:

1) Depends on whether you choose to invest in index-type funds (where profit is mainly expected from price appreciation), or more value-based investing. But either or a mix of the two (my own choice) should show returns above inflation, over the long term.

2) Yes, in the US anyway. You can invest a few hundred dollars at a time, and (with good companies like Vanguard & T. Rowe Price) there are no transaction fees, either for investing or for redeeming.

3) Long-term, it's crash-proof IF you have the self-discipline not to panic-sell at market lows. In my case, my total fund valuation dropped around 40% in '08. I didn't sell anything (and in fact tried to cut spending and invest more), and now I have nearly double what I had before the crash.

Bottom line is that it has worked for me. After ~30 years of investing this way without being fanatic about it, I have enough that I could live moderately without working for the rest of my life. Not - and this is where I part company with MMM and most of the FIRE community - that I'd ever want to actually retire. But my modest financial independence gives me the freedom to work at things I like, rather than because I'm worrying about paying bills.

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See the following information:

http://www.bogleheads.org/wiki/Treasury_Inflation_Protected_Security

You can buy individual bonds or you can purchase many of them together as a mutual fund or ETF. These bonds are designed to keep pace with inflation.

Buying individual inflation-protected US government bonds is about as safe as you can get in the investment world. The mutual fund or ETF approach exposes you to interest rate risk - the fund's value can (and sometimes does) drop. Its value can also increase if interest rates fall.

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