A Software Engineer’s Perspective: Why and How to Invest for Retirement
I’ve been getting a lot of financial questions lately. Probably because I’ve been entrenched in learning all that I can about investing and seemingly the more I research and learn for myself about finances the more questions I get from people asking me about what they should be doing. And I’m happy to oblige! Quite honestly, the increase in questions is likely prompted by my own increase in my desire to discuss financials! It’s all I want to talk about lately. This article is to distill, at a very high level, all of what and why I’m doing what I’m doing so that perhaps you can learn a thing or two for yourself. Future articles will discuss more detail and specifics.
Disclaimer: This article is not financial advice. I have not taken into account your personal situation. This is what I am doing for me, what is best for you may be similar, but do not make life decisions based solely upon what you read from a random stranger on the internet.
Let’s start with WHY I’m Investing:
Simply put, I want to get into a position where I don’t have to work. That’s not because I hate what I’m doing. I think my career is going great! However, I realize that staying an astoundingly great software engineer forever is incredibly difficult. Times change impressively fast, especially within the software industry. Do I think I can be great at 50/60 years old? Yes, of course. There are plenty of older software engineers who perform incredibly well. But I don’t truly want the pressure of needing to work a 9-to-5 when I’m 70... I also don’t think I’ll be able to keep up with all the new young talent when I’m 50+. There are plenty of people who I have worked with throughout my career who are older and perform very well, and that’s wonderful! I just don’t want to feel forced to, if you get what I mean. I want to have the option of reclaiming my time as my own rather than feeling trapped or obligated to show up every day to a 9-to-5. No matter how well paying or fulfilling that 9-to-5 may be, any job will always have me feeling beholden to someone else. So, I’m investing today in order to not have to stress tomorrow.
I’m not in a rush to achieve that goal. My investment strategy plays for the long game. I’m not just planning for next year, or even 5 years from now. I am preparing for 30+ years from now. I’m 29 years old at the time of writing this article so the strategy is sound. Compound interest is my chosen ticket to financial freedom. The strategy has historically worked wonders for others. Clearly, with my superior intelligence, it’ll work even better for me right?! (Insert a touch of sarcasm here) That’s the idea anyway. Reach out to me in 30 years and ask me how it went!
Where am I Learning From?
I’m a firm believer that you can learn anything on YouTube… However, YouTube isn’t great at guiding from the beginning steps to the end. So there are a couple of books that I’ve been reading/listening to lately that I believe have been great sources of actionable material. I started by listening to the first book, then I listened to the second book, then went back to the first book and purchased a hard copy. I am now reading the first book for the second time and keep it on hand as reference material. Audiobooks are great but they’re hard to bookmark and reference quickly. These two books which have taught me well are:
- “The Intelligent Investor” by Benjamin Graham
- “Invested: How Warren Buffet and Charlie Munger Taught me to Master my Mind, My Emotions, and My Money (with a Little Help from My Dad) by Danielle and Phil Town
The first book, The Intelligent Investor, is a well known classic originally written in 1949 by Warren Buffet’s mentor, Benjamin Graham. It has often been updated so I’m currently reading the 2003 version. In the book, Graham defines two investment strategies that are time tested. However, it took me a while to be convinced that either strategy was right for me. Currently, I deploy both in one way or another. In the book, they are named the “Defensive” investor and the “Aggressive” or “Enterprising” investor. I originally identified most with the “Defensive” investor but after reading the second book, Danielle and Phil Town’s Invested: How Warren Buffet and Charlie Munger Taught me to Master my Mind, my Emotions, and my Money, I am now exploring how to transition more towards learning how to be a slightly more “Aggressive” investor. After contributing enough to achieve my full employer 401k match and maximizing the allowed Roth IRA contributions, the remainder of my savings are to be contributed to a taxable brokerage account in order to invest in individual companies.
The Defensive Investor Strategy:
The core of the Defensive investor strategy is to, somewhat blindly, dollar-cost-average over long time horizons to reap the benefits of how stocks generally trend upwards over time at a rate that has historically outpaced inflation. My strategy for my employer 401k and my personal Roth IRA is currently to invest using index funds broadly diversified over the global economy and religiously contribute to these accounts immediately upon receiving each paycheck. If stocks go up, great! I will buy more. If stocks go down, that’s great too! My static monthly contributions will now buy even more stocks than before! No matter the price of the index fund, I always contribute immediately at the present market value. This requires no thought as it is all automated. The only effort required to be done manually is that once per year I will re-balance my portfolio. Because I am beginning so young, I want to have 90% of my holdings in stocks and 10% of my holdings in bonds. If on January 1st, 2021 stocks have grown to become 93% of my portfolio. I will sell 3% worth of stocks and purchase 3% worth of bonds to restore my 90/10 spread. Done until January 1st, 2022.
I use the late John Bogle’s creation, Vanguard index funds, to produce this broad diversification. A simple three-fund portfolio provides all the diversification I feel is necessary for me.
- Vanguard Total Stock Market Index (VTI) — 70%
- Vanguard Total International Stock Market Index ( VXUS) — 20%
- Vanguard Total Bond Market (BND) — 10%
These three funds provide the skeleton of a Defensive Investor’s index fund portfolio. Generally, most broadly diversified index fund portfolios are some variation upon the above. With more knowledge will come more ability to customize the approach. But, for now, this three-fund portfolio is what I currently use. I will likely more heavily weight my US stock exposure away from small-cap and growth stocks and more towards large-cap value stocks by selling 10% worth of VTI and purchasing 10% worth of Vanguard's Large Cap Value Fund (VTV). There are many schools of thought for how one should emphasize more towards one class of assets or another. After reading Betterment.com’s white papers on the subject of how they decided upon their allocations, I’m leaning towards being convinced to more closely mimic their strategy for my defensive investment portfolio. Hence the desire to lean more heavily towards value stocks.
The reasoning for choosing index funds over actively managed funds is almost entirely due to fees. I personally believe that it is possible for actively managed portfolios to regularly out-perform the broad market as a whole. (Warren Buffet has done it) But it’s much more difficult to do so once you account for the fees. The expense ratios (fees) for Vanguard’s funds are near 0.04% of managed assets per year where some actively managed funds charge upwards of 3% of managed assets per year. The differences are staggering and over the long run most actively managed funds, fees considered, do not out-perform the passively managed funds for the individual investor. Especially when you realize that the ~3% fee is levied against you whether or not your portfolio performed well. This means that your losses are magnified and your gains are reduced. Even still, some active managers do indeed provide value in excess of their fees when compared to the passive market indexes. However, choosing that active manager is, in my opinion, similar in difficulty to choosing individual stocks. So when faced with the task, why not just pick stocks yourself?
This is where becoming your own active manager comes in.
The Case for the Aggressive Investor: Actively Managing Your Own Portfolio:
The problem with broadly diversifying across the stock market as a whole is that there is no discrimination or price discovery involved. While you will rightfully own portions of every wonderful publicly traded business in existence, you will also own the terrible ones at whatever price the market demanded on your chosen day of purchase. The goal of the Aggressive investor is to take advantage of market inefficiencies; if you so believe they exist.
There are several advantages that you have as an individual investor that separate you from the large hedge funds.
- You aren’t investing several millions of dollars at once.
- You don’t have any external pressure from your customers.
- You don’t charge yourself fees.
- You can personalize to the extreme.
Each of these advantages is simple yet subtlety complex due to how nuanced the advantage truly is. The first advantage that the individual investor has over the large hedge funds is that your actions on the stock market do not greatly affect the price of the asset you’re looking to trade. Because you personally will not be making trades of several million or billions of dollars, you as an individual investor have little to no impact on the price of the asset you’re seeking to trade. If you see a stock trading on the market at a certain price, there are only a limited number of investors willing to actually buy or sell at that given price. In order to fill a single several million dollar buy order, you might exhaust all people willing to sell at that price before you’ve completed your purchase. This, in effect, drives the price up because to fill your order, your broker needs to continue purchasing at increasingly higher and higher prices. As a small individual investor, you can invest in a greater variety of businesses at a magnitude that is inaccessible to large fund managers. Being small is an advantage. Think of yourself as a small speed boat using the waves for speed while the large cruise ships can’t use the waves, but instead create their own.
The second advantage is that you as an individual investor do not have the added pressure to constantly be living up to expectations since you are your own customer. What often happens to the large fund managers is the pressure from their customers forces them to always be actively doing something even when passively doing nothing may be the correct choice. Customers are often fickle and will leave an active manager’s fund to join another’s who IS actively doing something. This forces fund managers to have a more short-term outlook for their fund. They’re judged on a yearly or quarterly basis. You as an individual investor need not worry about the micro when you know your goal is to reap benefits several years into the future. You can truly have a long time horizon, large fund managers cannot.
The third advantage is simple. Because you don’t charge yourself a fee to actively manage your own portfolio, you can pocket the difference and use the retained capital to further your investments!
Lastly, you can personalize to the extreme. Do you think that the moral decisions of company X are reprehensible?! Don’t invest in them! Investing in your principles is an important factor in my opinion. The less your views align with an organization the less interested you will be in them. The less interested you are, the less you'll pay attention to how that business changes over time! The less you pay attention, the harder it will be to turn a sustainable profit over the long term.
To summarize quickly, my investment strategy is simple. Your savings rate is probably the most impactful factor in achieving financial freedom so I’m currently saving ~50% of my after-tax income. With those savings, I first contribute all the pre-tax dollars required to ensure that I obtain the entirety of my employer’s 401k matching. Then, I contribute the maximum allowed by the US Government into my Roth Individual Retirement Account (IRA). Finally, with the remainder of my savings, I am investing in individual stocks and saving to invest in real estate (I.e. saving enough for a down payment to purchase a primary residence which I intend to move out of and rent to tenants relatively quickly). Is this the best way to invest? I have no idea! But, these are my current actions which are backed by an obsession with finance YouTube channels, a few investment books, and my two cents.