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What is The Simple Path to Wealth about? What advice does J.L. Collins give to beginner investors?
In The Simple Path to Wealth, blogger and financial expert JL Collins offers a simple road map to achieving financial independence and a secure retirement: Spend less than you make, avoid debt, save “F-You Money,” and invest in stock index funds. He demystifies stocks and bonds, as well as a plethora of investment plan options.
Below is a brief overview of The Simple Path to Wealth by J. L. Collins.
The Simple Path to Wealth: Your Road Map to Financial Independence and a Rich, Free Life
Most people realize money is important for getting what you want out of life—but they don’t want to spend a lot of time thinking about it. The Simple Path to Wealth grew from a blog series Collins subsequently wrote simplifying money and investing for his young adult daughter. To get along in the world, you need to understand money, he argues. Your options are to take charge of your money—put it to work for you as your “servant”—or be mastered by it.
Of course, everyone has better things to do than obsess about money—for instance, live your life, raise children, make your mark on the world, or enjoy retirement. But ignoring money leaves you open to being taken advantage of by financial advisors who profit from your ignorance by, first, convincing you that you need help, then by selling you complex and costly investments that perform poorly.
In contrast, The Simple Path to Wealth by J.L. Collins argues that investing isn’t complicated—you can do it yourself. Collins’s “simple path” is: Spend less than you make, stay out of debt, and invest in index funds. If you follow this prescription, you’ll end up wealthy and live a more fulfilling life.
Take Two First Steps
Before starting to invest, do two things:
1) Save until you have “F-You Money,” a financial cushion that gives you the ability to make choices about what you want to do rather than being a victim of your circumstances. For example, having F-You Money allows you to walk away from a job you hate, take a “sabbatical” to do something you dream of, or avoid poverty if you’re laid off.
F-You Money, plus the money you invest for your long-term future, both buy you freedom—and your freedom is the most important thing your money can buy. Ultimately, your goal is financial independence: the point where you can live on 4% of your nest egg a year without having to work for the rest of your life. (Your nest egg remains stable or grows if you withdraw only 4% a year and the market grows.)
2) Get out of debt. While borrowing gets you the latest consumer products, it keeps you from saving and building wealth because your income is consumed by debt and interest payments. Also, debt makes you a slave to your employer: You have to stick with your job, even if you hate it, because you have to make debt payments.
Change Your Mindset
The rest of the book focuses on investing, which requires changing your mindset about money. To build wealth and become financially independent, stop thinking about money in terms of what it can buy and instead think of it in terms of what it can earn.
Wealth accumulation is made possible by compounding, in which money you invest earns interest, and you add the interest to the original sum, making it larger so it earns even more interest. With compounding, a relatively small amount of money invested in stocks grows significantly.
Here’s how it works. Based on the average market return of 11.9% a year with dividends reinvested from 1975-2015:
- If you invested $12,000 in stocks in 1975, it would have been worth $1,077,485 in 2015.
- If you instead invested just $130 a month or $1,650 a year for 40 years, you would have accumulated $985,102.
- By increasing your $130 a month to $150 or $1,800 a year, you would have accumulated $1,136,656.
But you don’t actually have to wait 40 years to achieve financial independence:
- If you made $25,000 a year and invested half or $12,500, you could be financially independent in around 11.5 years (drawing 4% a year on accumulated wealth of more than $312,500 and continuing to live on $12,500 a year).
- If you decided to live on your full salary of $25,000 when your nest egg reached $312,500, and you just left your nest egg alone for 10 years, it would grow to $961,946 without your adding anything. If you quit your job after 10 years, you could draw $38,478 a year at a rate of 4%.
Stock Market Truths
To invest successfully, you must understand and accept certain truths about the market:
1) The market is the most effective wealth-building tool ever: Your money should be in the market working as effectively as possible for you as soon as possible. Collins touts Vanguard’s VTSAX Total Stock Market Index Fund as the simplest and most effective investment for tapping into the market’s wealth-building capabilities. (Collins notes that he isn’t being paid by Vanguard to promote its funds.)
2) The market always goes up over time: You can predict that it will be higher in 10-20 years than it is today. It’s been on an upward trajectory for 120 years. The Dow Jones Industrial average started the last century at 68 and ended at 11,497 (in 2010). As investor Warren Buffett has pointed out, this period included two world wars, a depression, periods of high inflation, oil shocks, and a dozen recessions and financial panics. Despite dips, the market maintains an overall upward trajectory.
3) The market is volatile: Market crashes (drops of 20% or more) are inevitable—a major plunge typically occurs about every 25 years, plus there are more frequent smaller drops in that timeframe as well as several bull (increasing) markets. There’s always a major crash somewhere ahead—for example, on October 19, 1987, on Black Monday, the market suddenly dropped 22% or 500 points. In addition, even bigger disastrous events like the 1929 Great Depression are part of the predictable process.
4) Investing successfully requires accepting risk and having the discipline to stay the course during downturns: To succeed as an investor, you’ll have to prepare yourself intellectually and emotionally for downturns and tough them out. If you panic instead and sell, you’ll lose.
How to Invest: Three Questions and Three Tools
Investing doesn’t have to be complicated, and you don’t need an advisor to help you. In fact, it’s easier and more profitable for you when you keep it simple. Getting started in investment requires answering three questions and applying three wealth-building tools.
The Three Questions
1) What investment stage are you in: the wealth accumulation (income-producing) stage,
the wealth preservation (post-working) stage, or a combination (for instance, you’re between jobs)?
2) What level of risk are you comfortable with?
3) What’s your investment horizon—how many years do you plan to spend accumulating wealth? If you’re just starting your working life, your investment timeframe will be longer than if you’re close to retirement.
These questions are interrelated in that your risk tolerance will correspond with your investment horizon—you’ll take more risk early on and less later as you near retirement. Also, your level of risk and investment horizon will drive your investment strategy. Your job and future plans factor into all three questions. For example, if you’re planning to retire early, you’ll have a shorter investment timeframe, and you’ll want to reduce your risk and preserve your wealth.
The Three Tools
The next step after answering the three questions is building your investment portfolio. To do it, you need three tools: a stocks index fund, a bonds index fund, and accessible cash held in a money market or bank account, or a money market fund.
1) Stocks: Collins’s preferred option is investing in VTSAX, Vanguard’s Total Stock Market Index Fund. Stocks give you the best returns over a long timeframe and because they grow in value, they serve as a hedge against inflation.
Index funds like VTSAX are groups of stocks chosen to passively replicate the market’s performance. In contrast, actively managed mutual funds are stocks chosen and managed by professionals who attempt to outperform the market. Collins recommends index fund investing over managed funds because index funds get better results and have lower fees. The chances of anyone regularly selecting stocks that beat the market are minuscule, so you can get better results by buying into an index that contains a lot of stocks that grow steadily over time.
2) Bonds: When you’re nearing retirement, you’ll want to shift some money (about 25%) from stocks into bonds, which are less volatile. Bonds pay interest and counter the ups and downs of your stocks fund. They also serve as a hedge against deflation (declining prices) because in these periods, bonds increase in value. Collins’s choice is VBTLX, Vanguard Total Bond Market Index Fund.
3) Accessible cash: You need accessible cash for expenses and emergencies. It’s also another deflation hedge. When prices drop, your cash buys more. But when prices rise, cash buys less. Don’t keep more cash than you need because when interest rates are low, cash has little interest-earning potential. You can keep your cash in a checking account or a money market account, whichever offers higher interest.
Investment Plan Options
Your two index funds (stocks and bonds) are your investments. Next, you need an investment plan or account in which to hold them. Options include 401(k), 403(b), TSP, IRA, and Roth accounts, which are tax-advantaged accounts.
The government created tax-advantaged accounts to encourage people to save for retirement. The dividends, interest, and capital gains earned by investments in these accounts (except Roth accounts) aren’t taxed until you withdraw the money. There are many varieties of 401(k) and IRA accounts; this section looks at the basic account types.
Employer-Provided Plans
In an employer-provided investment plan, such as a 401(k), your company hires an investment firm that offers a range of investment options such as VTSAX or other index funds. When you choose funds and contribute, many companies will match your contribution up to a limit. There’s an IRS cap on the amount you can contribute annually; Collins recommends you choose an index fund and always contribute the maximum. Here are some comparisons of features:
401(k) and 403(b) Plans
- Your contributions are tax-deductible.
- You’ll owe taxes when you withdraw the money.
- You’ll pay a penalty if you withdraw money before age 59½.
- You have to make RMDs, or required minimum distributions (mandated withdrawals), starting at age 72.
Roth 401(k)
- Your contributions are not tax-deductible.
- The earnings from your investments are tax-exempt.
- Anything you withdraw after 59½ is tax-exempt.
- You have to make RMDs starting at age 72.
- There isn’t any income limit for participating, as there is for a Roth IRA (more on this below).
TSPs (Thrift Savings Plans)
TSPs or Thrift Savings Plans are tax-deferred retirement plans similar to a 401(k) for federal employees, including members of the military. TSPs offer five basic types of low-cost funds, including an option that tracks the S&P 500 index.
IRAs
IRAs are tax-advantaged accounts you hold individually in addition to employer-provided plans like 401(k)s.
- You can only contribute earned income or money rolled over from an employer plan to an IRA. Earned income is money you’re paid for your work (which has already been taxed).
- There are several types of IRAs. Deductible IRAs and Roth IRAs have an income limit, but non-deductible IRAs have none.
- There’s an annual cap on the amount you can contribute, with a higher one for those age 50 and older.
Deductible IRA
- Contributions are income-tax deductible (this is phased out as income increases).
- Taxes are deferred on your earnings but are due when you withdraw money.
- There’s a penalty for early withdrawals.
- RMDs apply.
Non-Deductible IRA
- Your contributions are not tax-deductible.
- There aren’t any income limits for participation.
- Taxes are deferred on your earnings but are due when you withdraw money.
- You don’t pay any taxes on your original contribution because it was made with “after-tax” money. (Figuring out what you owe can be complicated.)
- There’s a penalty for early withdrawals.
- RMDs apply.
Roth IRA
- Your contributions are not tax-deductible.
- Your eligibility to contribute is based on your income level. You can’t contribute to a Roth IRA if your income exceeds an annual limit.
- After age 59½, the money you withdraw is tax-free.
- You can withdraw your original contribution anytime without a tax or penalty.
- After five years, you can withdraw contributions that were transfers from a regular IRA without a tax or penalty.
- You can withdraw money anytime for a first-time home purchase or college-related expenses.
- There are no RMDs.
Collins recommends that when you leave your job, you roll your 401(k) into an IRA to retain the tax advantage.
Withdrawing Your Money
When you stop working or retire, a key question is: How much money can you withdraw from your portfolio each year without running out of money before you die?
The common recommendation of 4% a year (the 4% rule) is one piece of retirement advice that actually works. The rule was developed in 1988 by three professors who ran computer simulations to test the impact of different percentage withdrawal rates on various portfolios over a 30-year period. They updated the research in 2009 (adding another 21 years). They found that:
- Over 30 years, a portfolio split 50-50 between stocks and bonds, with a 4% withdrawal rate adjusted for inflation, remained stable 96% of the time.
- In 55 years, the portfolio lost ground only twice. In the other 53 years, it continued to grow robustly, meaning the investor could have withdrawn more than 4% without reducing the total.
Collins draws the following conclusions:
- Withdrawing 3% or less a year is as close to a safe bet as you can get.
- If you hold 75% of your assets in stocks and 25% in bonds, you can safely withdraw under 4% a year and take an increase for inflation.
- If you don’t take annual inflation increases, you can withdraw up to 6% a year while keeping a balance of 50-50 in stocks and bonds.
- You can withdraw as much as 7% if you watch the market and, if it drops, cut back on spending and withdrawals until it rises again.
- Collins’s personal strategy is to withdraw around 5%, but to reduce withdrawals to 4% if the market drops.
It’s also important to be flexible—if you can reduce your expenses when necessary, find temporary work, or move to a cheaper area, you can add a layer of security regardless of the withdrawal rate you choose.
Setting Up Your Withdrawals
The process of withdrawing 4% a year from your investment portfolio is simple:
- Request that your investment firm transfer to your bank account a certain amount of money weekly, monthly, or however often you choose.
- Also request that ongoing capital gains, dividends, and interest be transferred to your account.
- Or log in to the website and transfer money yourself anytime (or combine automatic and manual transfers).
Drawing Social Security
The Social Security system has been sustainable in the past, but as large numbers of Baby Boomers retire and live longer, the payroll taxes that support it will fall short of payouts if nothing is done to fix it.
Thus, depending on your current age, your experience with Social Security likely will vary:
- If you’re 55 or older, you’ll collect the full amount you’re entitled to because politicians won’t take anything away from such a large group of voters. That’s why the solutions proposed so far to shore up the system only affect those 55 and under.
- If you’re under 55, you’ll receive benefits, but they’ll be smaller than those older recipients are getting today.
Although Social Security likely will survive in some form, plan as though Social Security won’t be there for you—that is, follow the simple path to wealth of living beneath your means, staying out of debt, saving F-You money, and investing in index funds. If you get Social Security, it will be a bonus.
Deciding When to Take the Money
If you’re 55 or older, you need to decide when to start claiming Social Security benefits. You can start at age 62, but the sooner you start, the smaller your checks will be. The longer you hold off up to age 70, the larger they’ll be, but you’ll have fewer years to collect them.
Some advisors offer complicated strategies, but as with investing, you’ll be better off keeping things simple. Consider the following in order:
- When do you need the money? If you need it now, take it—but for each month you’re able to delay, your monthly payment will increase.
- How long do you expect to live? Are you in good health? Do you come from a long-lived family? The longer you live, the more you stand to gain by delaying payments. The break-even point for people between the ages of 62 and 66 is 84, meaning that if you live longer than 84 years, you’ll collect more if you wait until after age 66. You might want to claim benefits sooner if you don’t think you’ll live to age 84.
- If you’re married and earn more than your spouse, when you die, your spouse can swap their benefit for your larger one. If you put off taking Social Security until age 70, your surviving spouse will get more. In the interim, they can claim their lower benefits.
Conclusion
Encapsulating the principles in this book, here is the initial 10-year investment path that Collins recommended for his young-adult daughter at the start of her career:
- Avoid debt.
- Spend the first decade of your career working hard to build your skills and reputation.
- Take time for (inexpensive) adventures.
- Don’t increase your spending as your income increases. (Remember, financial independence is not only about building wealth, but also about controlling your spending.)
- Invest half of your income. Put it in VTSAX or a similar fund.
- Make the maximum contribution to your 401(k) plan, especially if it offers an employer match.
- Fund a Roth IRA when your income and taxes are low; when your income rises, fund a traditional IRA.
Collins told his daughter that if she did these things for the next decade, she’d approach financial independence in her early-to-mid-30s.
Once you’ve achieved financial independence and can live on 4% of your investments, continue your career or do something new. If you keep working, invest all of your income (which will increase the amount 4% represents). Consider buying a house, having children, and giving to charity. The reason you save and invest is to create options and opportunities to enrich your life.
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Here's what you'll find in our full The Simple Path to Wealth summary :
- A simple road map to achieving financial independence and a secure retirement
- How to put your money to work for you as your “servant”
- Why you don't need a financial advisor to help you invest
