This weekend, a law clerk at a bankruptcy court messaged me. She’s planning on moving on to a law firm in the coming years, and wanted tips on how to plan ahead to be smart about investing. That kind of experience could easily net her a job that pays $200,000. So what should someone do with that money?
It’s smart to be learning about investing now. Learning the basics of personal finance and investing before I earned a biglaw income helped me internalize the principles and think about how to build in systems to make it easy to use my money thoughtfully. It also got me excited – I couldn’t wait to start making money because I knew what to do with it. And as I emphasize below, if you begin before lifestyle creep takes over, you’re putting yourself in the best position to live within your means and save and invest the rest. If you’re already practicing, you can start now and avoid the downward spiral.
The most important thing is, as trite as it sounds, to save as much as possible. It’s the best insurance to make sure you have the most amount of capital working for you. I don’t want to neglect the value of earning more, but saving is the thing you have the most immediate control over. You will be earning over six figures as an attorney, and no one with that kind of income can credibly say “I can’t save more money.”
So you want capital, what is capital? Capital isn’t just dollars, and it isn’t just stuff, it’s all about assets. Assets are (1) things you own (2) that have the potential to increase in value over time. The best way to identify assets are to look for things that generate income. Bonds are assets, because these are contractual obligations to return interest over time. Stock are assets, because these represent ownership of a company that is earning income. Real estate is an asset, because you can rent it out. Note that you don’t need to have full ownership of an assets, you can share ownership. That makes it easier to collaborate with others for joint enterprises. And that makes it far easier to start, because you just start buying incremental pieces of businesses (like stocks).
What won’t we consider to be assets? Cars (with narrow exceptions, these decrease in value over time). Collectibles (unless you’re an expert). Lottery tickets (no exception, but by all means play it for fun).
Why do you want capital? Capital works a certain kind of magic. Capital increases in value over time, through no additional effort from you. You earn income, and then you use that income to acquire assets. While you’re off earning more income, the assets continue to increase in value – the assets either throw off cash you can use to acquire more assets, or they assets increase in value in recognition of the increase in cash those assets gained.
The basic math of return on capital is pretty amazing. let’s say you were fortunate and bought Apple stock at half of today’s valuation. So now your capital has doubled. That’s pretty good. And now you’re thinking to yourself – maybe this is a good time to sell. After all, how likely is it Apple will double in value yet again. But some pretty simply math shows that even if Apple experience a slowdown, it can still be immensely profitable to such a shareholder.
Let’s say you had $5,000 in Apple stock that appreciated to $10,000. And when you bought, Apple generated $1,000 of revenue per year as allocated to your $5,000 worth of ownership. That’s a 20% return annually (that’s really high). Let’s say that now that your Apple stake is now worth $10,000, but at this stage Apple is twice the size but it’s sales have declined so it still only returns $1,000 per year on that $10,000. That still amounts to a 20% return on the capital you put into the business. But it will leave an investor to consider whether there are greater gains to be had on the $10,000 – to the extent there are opportunities to once again get a 20% return, they should be pursued. But even a reduction in returns for the company can still mean your rate of return on your capital is strong.
Because the compounding effect of capital growth is so powerful, a dollar invested today is so much more valuable than a dollar invested a year from now. The more you save and earn, the sooner you can invest those dollars. It’s fun to spend dollars today. But if you are able to see the kinds of returns you can get tomorrow and realize that if you were that are today, you’d be able to have that quality of life based on that net worth, it becomes easier to picture where you’re heading.
A simple rule of thumb for calculating compound growth is the rule of 72. It’s a mathematical property that makes it easier to calculate growth. You take an annual rate of return and divide 72 by that number to figure out how long it would take to double your money. So at a 2% rate of return, it would take 36 years to double your money. If you look at the average rate of return of the Vanguard Total Stock Market index fund for the past 20 years, it’s 7.2%. So following the rule of 72, the number of years it would take to double your money if you invested in this fund comes out to an even 10 years.
When you get a high-income job, the thing you must do is fight like hell to avoid increasing your expenses. My first semester in law school, my budget for dinner at McDonalds was $3.30. The next semester I graduated to $5 footlongs at Subway. The semester after that I allowed myself to get Jimmy John’s. I didn’t drink much because I just couldn’t afford it.
What you have to recognize is that your surroundings matter, and it takes extra effort to stay disciplined. If you are trying to cut back on drinking alcohol, you know that it’s smart to spend less time going out with your friends to bars, or that if you go with them you have to plan in advance how to handle questions about the club soda you’re ordering (and how to say no to a shot). To stick to your commitments you have to set up the right systems. But you also don’t have to suffer or be insufferable.
Your peers will spend more money. Period. it’s just what young professionals do. Most have some vague plan of working hard to make money now but changing later, but so many will spend their money to release stress and to just feel good about themselves, chalking up their behavior to being social or excuses that they can always save later. To avoid that trap, you have to come up with your own system of commitments that you can live by.
What are you willing to sacrifice today to get what you want tomorrow? I have learned that successful people consistently ask themselves this question and come up with actionable solutions. Are you willing to give up the nicest condo? Are you willing to give up eating out X number of times a week? Are you willing to not spend more than $Y dollars on clothes? Make it easy to commit yourself. And make sure you have money for fun. Figure out the most rewarding use of your money and focus on that. If you love to travel but clothes are only okay, then cut back mercilessly on clothing spend and feel free to use some of that extra money on travel and invest the rest.
I don’t think you have to do anything formal like a budget in order to save and invest effectively. But you should have a sense of how much you want to save, and work backwards from there to determine what expenses you can allow yourself. You should plan on maxing out your 401(k) (more on that later), building a cash reserve for six months of expenses, and investing additional savings in more assets. I’m not here to tell you how much to save or any rules of thumb. It’s really about what will bring you satisfaction that you are balancing enjoying today with providing for tomorrow and developing an acute sense of the value of a dollar tomorrow, as described earlier. Follow this system and you will be in a position where you can live for years off of your salary.
The 401(k) is simple. Most employers should offer one. Follow the paperwork when you get it, it should be very simple to set up. I recommend you contribute the maximum amount, which goes up every year. In 2021, for workers under 50 the maximum contribution is $19,500. The 401(k) is a tax-advantaged investing account. The dollars you put in the 401(k) are not taxed today but upon distribution. So you have more dollars to invest today because of it. And the tax benefit gets more valuable the more money you earn, because of the marginal tax brackets. As you increase your income, that income gets taxed at progressively higher rates. So shaving off the $19,500 taxed at the highest tax brackets creates the maximum tax benefit for you.
Remember, your 401(k) is not itself an investment – unless you tell the investment manager otherwise, it’ll just sit there in cash. As to what to invest in your 401(k), my recommendation if you don’t plan to touch the money for at least 10 years is to put it in a simple stock index like the Vanguard Total Stock Market index fund. There should be something equivalent if the investment manager doesn’t offer Vanguard funds. Set it and forget it. The less often you check, the better. The value of stocks will go up and down. In a given year, if the stock market is declining you may contribute more than how much the value of your account increases. That’s okay. You’re not here to time the market. You’re here to stay consistent, knowing that over time it pays off. As for myself, 40% of my net worth comes from appreciation of assets. I can tell you it works.
Real estate is complicated. I’ve had a complicated relationship with it. I bought and sold a condo in Chicago and briefly rented it out. It was profitable, and I loved my condo. But I think people underestimate the value of the flexibility and lack of responsibility with renting. I’m a big believer in living in different parts of the nation, and while that raises additional challenges for attorneys like myself, it’s worth it. You only live once, why not enjoy exploring? I’m frankly not qualified to speak to the value of real estate as an investment in the long run. But check in with me in ten years.
It’s a good idea to get a credit card because our current credit system values a good history of credit card usage. You may think it’s obvious but I couldn’t stress this enough – pay your bill in full every month. Treat it like cash in the bank. If you do that, you’ll be fine. Don’t get tricked into chasing credit card rewards. I think Chase has the best credit cards, so whether you want to get something that tailors rewards for travel like the Sapphire Reserve or you want a simple card with no annual fees, they have the best rewards and the best customer service. I’ve had Chase cover damage to vehicles, credit card fraud, they just do a good job..
Another thing, don’t get suckered into chasing airline miles. It’s a potent drug for the upper-middle class. I know people that will do “mileage runs” at the end of the year to rack up the points to maintain their status on an airline. This consists of (1) boarding a plane in Chicago (2) flying 30 hours to Hong Kong (3) stepping off the plane for a few hours (4) flying 30 hours back to Chicago. You tell me if that’s worth it.
Resources
I like Ramit Sethi’s I Will Teach You To Be Rich. I hate the title (but he’s the marketing expert, not me). The chapter on 401(k)s should be helpful to you to explain how they work and why they work for you. I like how he thinks about systems to make it easier to commit to savings by using automatic allocations and separating your savings into different accounts for different kinds of spend (including fun). There is a great podcast episode with Ramit on The Tim Ferriss Show.
John Bogle is the late founder of Vanguard. I don’t think anyone has done more to democratize investing than him. Because he innovated index funds that made it cheaper to invest the more people invested in them, he created a system that has driven investing to cost orders of magnitude cheaper. Check out Bogle’s The Little Book of Common Sense Investing.
Read Bloomberg Businessweek. They have consistently the best coverage of financial markets, balancing sympathy with criticism. The WSJ has too much of the former and the NYT too much of the latter. I highly recommend you subscribe to Matt Levine’s Money Stuff. It’s a free newsletter of his daily column. It’s not light reading but even the densest material is highly entertaining in his hands.