Ramit Sethi: How to Make More Money Investing

This article is an excerpt from the Shortform book guide to "I Will Teach You to Be Rich" by Ramit Sethi. Shortform has the world's best summaries and analyses of books you should be reading.

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Do you want to level up your investing game? What are some things you can do to increase your investment earnings?

Once you start seeing your investments grow—even by a little bit—you’ll start thinking about how to feed your financial growth even further. According to Ramit Sethi, the author of I Will Teach You to Be Rich, the first step to leveling up your investment game is to define a concrete reason for growing your wealth. Otherwise, you’ll risk what Sethi calls “living in the spreadsheet”: becoming so fixated on making money that you forget the purpose of having money in the first place.

In this article, we’ll dig down into the concrete reasons why you want to grow your wealth and some tips on how to make more money investing, according to financial educator Ramit Sethi.

Think About Your “Why”

If you want to learn how to make more money investing, first ask yourself: if I’m already making enough money to live comfortably, why do I want to make more? Your first answer might be high-level ideals like “freedom” or “security,” but it’s hard to motivate yourself with abstract ideas. Instead, make the abstract more concrete: Rather than “security,” maybe you want to make more money so you can create college funds for your children or buy the house you’re currently renting. When you focus on a concrete vision, you give yourself a specific goal to shoot for and avoid the trap of making money for its own sake.

Feed Your System

Once you have a clear vision for why you want to grow your wealth further, you’ll want to focus on pumping more money into your investments. Remember, the more you invest early on, the more that money will grow due to compounding—so every extra cent you can funnel into your investments will create huge returns later on. To free up more money for investments, you look at your plan for expenditure to see where you might be able to optimize even further (for example, by putting off major purchases like a car or a house). If you’ve squeezed every possible dollar out of your spending plan, you may need to increase your income by negotiating a raise or looking for a higher-paying job.

Rebalance Your Investments

If you handpicked your own investment portfolio, another way to optimize your finances is by rebalancing your investments once a year (if you chose to invest through a target date fund, you don’t need to worry about this because your fund will rebalance itself for you). That way, if one part of your portfolio performs better or worse than the others, it won’t throw your entire asset allocation off balance.

For example, let’s say you followed the Swensen model and allocated 30% of your investments to domestic equities. If your domestic equities fund booms in a particular year and nets 50% more returns, that means you’ll have more money (both principal and returns) invested in the domestic equities part of your portfolio than you planned. This also means that if that domestic fund were to crash, a bigger portion of your portfolio would suffer.

To protect yourself from wild swings in the market, you need to make sure that no one part of your portfolio grows too large relative to all the others. So if one area (like domestic equities) starts to grow, you’ll need to rebalance the portfolio by pumping more money into all the other areas (like international equities and bonds). You don’t need to conjure up more money in order to do this—just temporarily pause your contributions to the high-performing fund and reallocate that money so it’s divided among your other investments. Once your asset allocation is back where you want it to be, you can start contributing to the high-performing fund again (you may want to set up a calendar reminder so you don’t forget to restart automatic contributions).

If one area of your portfolio is underperforming, you can rebalance in much the same way. This time, instead of pausing payments to the fund that’s out of alignment, you’ll pause payments to all your other funds and reallocate that money toward the underperforming fund. Keep building up that area of your portfolio until your asset allocation is balanced again, then resume payments into all the other funds.

Avoid Selling Your Investments

As you consider rebalancing your investments, keep in mind that you should avoid selling any investments unless it’s absolutely necessary. This is especially true if you’ve held an investment for under a year: If you sell within a year of buying, you’ll have to pay income taxes on your earnings, which can significantly reduce your overall returns. However, if you wait at least a year to sell, you’ll avoid paying income tax on those earnings (you’ll still have to pay capital gains tax, but that’s typically much lower).

While it’s best to avoid selling your investments at all, there are three situations where you might need to: emergencies, underperforming investments, and achieving goals. We’ll cover each of these in more detail.

Emergencies

No matter how well you plan for your financial future, surprises happen. If you suddenly need money to cover unexpected expenses like medical bills or property damage, don’t sell off your investments as a first resort. Instead, start with the emergency fund you’ve saved up in your savings account. If that’s not enough to cover you, you can try to earn additional money with a side hustle or by selling off some of your possessions. Finally, you can ask your family for help.

If you’ve pursued all those options and are still short on cash, then you can consider withdrawing money from your retirement accounts. You can always withdraw the principal from your Roth IRA without a penalty, and your 401(k) should have options for “hardship withdrawals.” However, in either case, keep in mind that if you borrow even a small amount from your retirement accounts, you’re actually costing yourself more money down the line due to lost earnings from compound interest.

One caveat to this rule is that if your only other option is to use your credit card, then you absolutely should withdraw from your retirement account first. The earned interest you lose out on is nothing compared to the exorbitant interest rates your credit card will charge if you start to carry a balance. You should only use your card for emergency money if you’ve exhausted all other options.

Underperforming Investments

If you’ve followed the advice in this summary so far, all your investments should be in either index funds or target date funds, not stocks in individual companies. When the price of those funds fluctuates, it’s because the whole market (or at least that particular index) is trending up or down. In practice, that means there is very little use selling your investments, because the market as a whole almost always trends upward with a roughly 8% annual return averaged over decades. In the short term, if one of your index fund investments dips, you’re better off holding onto it because the market will almost certainly recover, even if it takes a few years.

However, let’s say that you invested some money in an individual company just for fun, and the price of that particular stock starts to decline. Before you panic and sell, step back and look at the industry context. If the entire industry is declining, there may be a temporary cause (like a supply shortage), in which case you can expect the industry to recover. (On the other hand, if you suspect that the entire industry is becoming redundant, you may want to sell.)

If the industry is doing fine, but the specific company you own stock in is suffering, that may be a sign of a more serious issue. In that case, you can sell your shares through your brokerage company’s website, but keep in mind that you may face tax penalties.

Achieving Goals

The best reason to sell your investments is that you’ve achieved your financial goals. For example, if you were investing to make enough money to afford a nice car, you should absolutely sell when you meet that goal and use the money for that purpose. This isn’t extremely common because you should be using your savings account for most of your short- and medium-term savings goals—but if you decide to invest with a shorter-term goal in mind, don’t hesitate to sell once you meet that goal.

Understand the Truth About Taxes

Another way to optimize your finances is to make sure you understand how taxes work. Common misconceptions about taxes can cost you money in the long run, especially if you avoid increasing your income due to fears about paying higher taxes. Here are some common myths about taxes and the real story behind them.

Tax Myth 1: Tax refunds are bad. Some people hate tax refunds because they see them as an interest-free loan to the government. Instead, they think we should get consistent, small tax refunds throughout the year instead of a lump sum at tax time. However, research shows that when people do get small tax refunds more frequently, they just spend the money without even realizing they’ve received a refund. On the other hand, when you get a lump sum once a year, you’re more aware of the amount, so you’re more likely to save it or put it towards debt rather than blowing through it.

Tax Myth 2: Increasing your income isn’t worth it because moving up a tax bracket will negate the extra money you make. This is a common misconception that can cost you tens of thousands in missed wage increases. In reality, American income taxes are calculated using “marginal tax brackets,” which means that if your income increases and you move up a tax bracket, you’ll only pay higher taxes on the portion of your income in the higher tax bracket. As an overly-simplified example, let’s say the upper limit of one tax bracket is $80,000 per year and you make $100,000 per year. In that case, you would only pay a higher tax rate on $20,000 of your income—not the whole $100,000!

Tax Myth 3: If you make enough money, you can use loopholes to avoid paying taxes. While there are some legal tax loopholes, they’re generally only available to the super-rich (people who earn millions of dollars each year off of their investments alone). Unless you plan to inherit millions or launch the next Google or Facebook, you probably shouldn’t worry about finding tax loopholes.

Ultimately, the “good enough” mentality should guide your approach to taxes: Use tax-advantaged accounts like 401(k)s and Roth IRAs as much as possible, then move on, taking comfort in the fact that the taxes you do pay contribute to important national infrastructure.

Ramit Sethi: How to Make More Money Investing