Investing For 21 Year Old

Reader Question

Hi, Currently im 21 years old and making $12 bucks an hour, In the next couple of years im going to be making $20 plus. I'm looking to invest in mutual funds. My friends are telling me to invest in Vanguard's Wellesley and Wellington. But after reading your articles about Vanguard Total World Stock Index Fund (VTWSX) and Vanguard Total Bond Market Index Fund (VBMFX). I don't know what to choose. May you please enlighten me.

My Reply

Before I get to a detailed reply, I want to first say great job thinking of investing at your young age! Stick with the mindset of saving and investing and in ten, twenty, thirty, forty years you will be very happy that you did. And big congratulations on having the type of friends who recommend investing in Wellesley and Wellington! While those two funds would not be my absolute #1 suggestion there is no doubt that they are near the top of the list of best all-in-one investments. Too many people, especially young people, are drawn to all sorts of get-rich-quick investments like tech stocks or gold or whatever else has been "hot" lately. To have your friends recommend something as fundamentally sound as Wellesley and Wellington is a tribute to them and to you.

Now, on to your question... My reply will be a bit long, but hopefully it will be worth your time. I will summarize the key points at the end.

What To Look For In Investments

First off, you won't go much wrong with either Wellesley and Wellington or with my older suggestion of VBMFX and VTWSX. There are three key properties that all good investment strategies have:

1. Rock bottom costs. Unlike with most human endeavors, paying more does not get you more in investing. In fact, it's the exact opposite. Paying high fees (primarily annual management fees, but also commissions, bid-ask spreads, as well as taxes) on your investments all but guarantees their poor performance. This is somewhat counter-intuitive and many people unfortunately never quite grasp this simple truth. Unlike all those other human endeavors, trying to beat the market is a zero-sum game of (almost exclusively) luck. In any such game the less you pay to participate the better off you'll be. Of course you'll hardly ever hear this from the financial industry or the many media sources that write for or about it -- their well-being depends on as many investors paying as much as possible for the "game". But the truth is that keeping costs low is paramount to your investing success. Vanguard -- a not-for-profit company -- consistently delivers the lowest or almost the lowest available costs on very wide range of investments. All four of the mutual funds you listed do a reasonable job of keeping costs low. Wellington's and Wellesley's are a bit higher than possible but that's unavoidable for actively managed funds. They could be a lot worse -- i.e. in line with the vast majority of the industry. My own old recommendation of VTWSX has not quite lived up to Vanguard's usual high standards in this regard, which is why I stopped recommending it on this blog (and will need to go back and add some asterisks by its mention in my older posts) -- more on that later. But overall, all four of these funds keep costs under control.
2. Widest possible diversification. Here Wellington and Wellesley come up a bit short but still meet what I would consider minimum acceptable level of diversification. They also happen to focus on investing in two areas -- US large cap value stocks and intermediate-to-long corporate bonds -- that have historically delivered returns slightly higher than the alternatives. I still prefer greater diversification, especially among stocks, but, again, you could do far worse than Wellington and Wellesley. More important than diversifying among all the possible stocks is diversifying your stock portfolio with generous helping of bonds. This is unfortunately something a lot of young people tend to ignore. But both my recommendations and Wellington and Wellesley do the right thing here and include plenty of bonds as part of the portfolio. 
3. Sticking with your strategy for years, through thick and thin. Sticking to it through the thin part is where bonds really help, by the way, because they cushion the blows delivered to your portfolio by inevitable bear markets. It's a lot more tolerable to watch your portfolio lose 20% in a bad bear market than 50%. The latter level of losses can and does drive many people to sell out of their holdings at worst possible time -- deep into bear markets. In any case, sticking with your strategy -- however you do it -- is very important. This part of investing ought to be mostly up to you but most actively managed mutual funds simply cannot seem to help but to change the types of investments they make over the years and decades (this is usually called "style drift"). The result is that they end up chasing "hottest" investments with predictably bad results. Wellesley and Wellington, despite being actively managed mutual funds, have -- as far as I know -- managed to avoid this problem for all the many decades of their existence (by the way an average mutual fund probably doesn't last even one decade). My recommendations are always index funds which follow a specific (usually very broad) index and can't have style drift by definition. 

So all four mutual funds you listed do a more or less good job of meeting these three key requirements. There are thousands upon thousands of other possible investments that fail in one or more of these.

Past And Future Of Wellesley, Wellington, And Bonds

Nevertheless it's never a bad idea to dig a little deeper in the investments you are considering. First, let's look at the most likely reason why your friends have recommended Wellington and Wellesley to you: their enviably high returns without too much volatility for the past 10-15 years. This will prove very instructive in learning to anticipate future investment returns as well... While the stock market swung violently between large losses and large gains, Wellesley and Wellington chugged along and ended up ahead all the while avoiding most of the scary volatility. What was their secret and why not invest just in them, as your friends suggest? 

Well, if we could guarantee a repeat of these past 10-15 years of Wellesley and Wellington performance, then indeed that's all we'd need for our investments. Unfortunately, as with most things in investing, recent past returns are a very poor indicator of immediate future returns. The "secret" to Wellesley and Wellington's great recent (past 10-15 years still count very much as "recent" in the world of investing) performance have been their large allocations in long-term corporate bonds. Fully 2/3 of Wellesley's portfolio have been invested in such bonds as well as 1/3 of Wellington's. The past 30 years have seen an absolutely unprecedented bull market for all bonds as interest rates went from record high to record low. Long-term bonds of the kind Wellesley and Wellington held are the biggest beneficiary of such bull markets (just as they would be the biggest victim of an opposite move in interest rates, from low to high). That is the secret sauce to Wellesley's and Wellington's outstanding returns with minimal volatility of the recent decades. If you are interested in digging more into this, check out http://www.longtermreturns.com/2012/09/wellesley-wellington-or-diversified.html .

Unfortunately, this huge past bond bull market is at its end. There is just not much room left for interest rates to fall to continue to fuel gains in bonds. Today's bonds already have record or near-record low yields and are poised for mediocre returns at best. And if the interest rates start moving the other way and start rising those same long-term bonds will be punished as the result. In fact, Wellesley's and Wellington's managers recognized this fact and more recently shifted from long-term bonds to intermediate-term bonds which sacrifice some of the potential return for more safety in case the interest rates start their march back up. The secret sauce that has fueled Wellesley's and Wellington's run has dried up. That doesn't mean these funds will turn out to be poor investments in the future, but it definitely means that they will not come close to repeating their outstanding performance of the past few decades.

Unfortunately the same phenomenon of today's record low interest rates affects all type of bonds, not just the ones held by Wellesley and Wellington. All bonds today are pricey. No bonds are likely to deliver high returns and, depending on how the unknowable future unfolds, some bonds -- especially the long-term variety -- may suffer large losses if and when the interest rates start to rise significantly. Which may prompt you to wonder why invest in bonds at all? That is a very fair question. The short answer is that today's bonds still return you more than cash does without being vulnerable to massive, sickening drops of the type that a bad bear market can wreak (and will sooner or later wreak) on stocks. In other words, if you want some of your portfolio to be in safe assets -- a very good idea for vast majority of people -- bonds are still your top choice. Just don't expect them to have returns anything like the past ten or twenty or thirty years. 

If stocks were obviously bargain-priced then it would make sense to ignore the pricey bonds altogether and pile into stocks. Unfortunately stocks are no longer anywhere close to bargain priced. They were bargain priced in late 2008 and early 2009. Now they are somewhere between fairly valued and pricey. Again, that doesn't mean you should sell them or stop investing in them. It just means that their future returns will be significantly lower than their past 3-4 years' returns.

I hope that by now it's clear that, unfortunately, bonds are destined for significantly below-average returns in the coming years and stocks would be lucky to achieve just average returns. That does not mean you shouldn't invest in them. It just means you should have realistic expectations of what they will deliver. Below-average returns of, say, 2-3% from bonds and, say, 6-8% from stocks are still much better than you can expect from cash or anything else. (Of course some people will tell you how they can achieve 20% returns or higher year in and year out by trading. It sounds like you're already smart enough to know to ignore these delusional lies.)

Deciding On Your Stock And Bond Mix

Before jumping to specific investments you need to first decide how risky or safe you want your investment strategy to be. I wrote a whole big article on doing just that: http://www.longtermreturns.com/2012/03/selecting-investment-strategy.html . I hope you read that article. I won't repeat it all here, but the gist of it is that you need to decide on what percentage of your portfolio you should always keep in "safe" bonds and what perfectage in "risky" stocks. As I mentioned earlier, Wellesley, for example, keeps two thirds in bonds and one third in stocks. Wellington does the opposite. There is no "right" answer as to what percentage should be in bonds and what percentage in stocks. Bonds are safe but will grow at snail's pace at today's valuations. Stocks have potential for good growth but are risky. They can plunge and sooner or later they will plunge. A 50% plunge from the peak of stock market to the bottom should be expected at least once every couple of decades. It happened twice in 2000's. You will not avoid it. You must be mentally prepared to stick to your strategy, to not sell stocks after they've plunged, and, ideally, to keep buying more of them on the cheap even as they're dropping day after day after day. This is a lot harder to do in practice than it might sound!

You must decide on the stock-bond mix of your portfolio and then you need to stick to that mix for a decade or five. Selecting anywhere from 20% to 80% of your portfolio to be in stocks and the rest in bonds is imminently sensible. Go with 50/50 or thereabouts if you really have no idea what percentages to choose.

Selecting Your Investments

Now that you've picked what percentage of bonds and stocks to hold in your portfolio, it's time to get to actual investment selections. There are a number of ways you can go here. You can go with your friends' advice of a mix of Wellington and Wellesley to get to your desired stock-bond mix (half in Wellington and half in Wellesley will result in a 50/50 stock/bond mix, for example) and stop there. But I think you can do even better.

As much as I'd like to keep recommending VTWSX for a one-stop stock solution, I simply cannot bring myself to do it because of its 0.40% expense ratio. I really expected Vanguard to lower it to at most 0.20% by now. A difference of 0.20% in annual expenses might not seem like a lot, but all those little fractions of percent really add up over the years and decades. So VTWSX is out. Instead of it, use a mix of VTSMX for US stocks and VGTSX for international stocks. You can very closely approximate VTWSX by investing equal amounts in VTSMX and VGTSX and save 0.20% a year in the process. Some people choose to keep more in US stocks (VTSMX) and less in foreign (VGTSX). Again, there's no right answer here but it is important to stick to whatever percentage of US and foreign stocks you decide on up front. You certainly should not sell US and buy foreign after you see foreign doing better or vice versa.

On the bond side things a little muddy too. VBMFX that I recommended in my earlier posts is still a fine choice. But because bond yields are so low there is now a clearly superior alternative in the form of I Savings Bonds. I Savings Bonds are not particularly great in absolute terms. It's just that all other bonds are worse still. On the downside, you can't invest into I Savings Bonds via Vanguard. You have to open a separate account with TreasuryDirect.gov. There's nothing wrong with doing that, but it is extra hassle. It also spreads your money more thinly, which might be a specific concern for you because of my next point: minimum investments.

Vanguard mutual funds are great but they do have some downsides. They have minimum investment requirements typically of $3000. They also have slightly elevated expense ratios until you have $10,000 invested in each fund (at which time you are switched to the lowest-possible-expenses "Admiral" version). Soon enough in your investing career this will not be an issue but for starters coming up with those minimal investments and then waiting till you have $10,000 in each fund for lower expense ratios can be frustrating.

Good news! Vanguard also has LifeStrategy mutual funds which take care of both problems. They still carry the $3000 minimal investments but each LifeStrategy fund is already composed of VTSMX, VGTSX, and VBMFX! So you only have to meet the $3,000 minimum once instead of three times: once for VTSMX, once for VGTSX, and once for VBMFX. Moreover, LifeStrategy funds always have near-rock-bottom 0.15% or so expense ratio, regardless of how much you have invested. Moreover, they automatically re-balance across their constituent funds to maintain set percentages in each which is a great feature that's likely to boost your returns -- remember, this would normally be up to you to do manually.

I very strongly recommend you to go with one of the four LifeStrategy funds depending on your preferred mix of stocks and bonds. They range from 80/20 to 20/80. I have the following (hopefully) helpful slide summarizing the four LifeStrategy funds you can choose from:

VASGX has 80% in stocks and 20% in bonds.
VSMGX  has 60% in stocks and 40% in bonds.
VSCGX has 40% in stocks and 60% in bonds.
VASIX  has 20% in stocks and 80% in bonds.

Pick one that comes closest to your desired stock-bond mix and keep investing in it your whole life!

Selecting Your Account Type

One last consideration is the type of account you should open. I would very strongly urge you to open a Roth IRA and contribute to it as much as you can every year, ideally right up to the annual $5,000 limit (though I realize of course that this may be out of reach for you until you have a higher paying job). A Roth IRA is custom made for your situation. It is not tax-deductible but your tax bracket is currently low so you don't lose much there. Instead Roth IRA gets to grow and eventually get spent in retirement completely tax-free. You will never pay any taxes on any of your Roth IRA gains. This is a huge deal. Do your best to max out the $5,000 limit in annual Roth IRA contributions and you will be extremely happy that you did so when you start thinking of retirement.

You can (and probably should) start your Roth IRA with Vanguard and put the initial $3,000 toward the LifeStrategy fund of your choice. Hopefully you will keep contributing $5,000 (or more -- Roth IRA limits are increased periodically for inflation) to that same LifeStrategy fund year after year after year.

Besides LifeStrategy and Roth IRA which are managed entirely by you, there is a good chance that your employer will offer some form of 401k plan -- ideally with a selection of low-cost index funds and with some employer match. You should definitely contribute enough to the 401k to get maximum employer match if it exists. Beyond the matched amount 401k is probably less preferable than Roth IRA for you because you are currently in a low tax bracket. So if you are torn on where to put your investments, first get maximum employer match in 401k, then stash away up to $5,000 per year in Roth IRA, then maybe come back and put remaining savings into 401k. 401k plans and selections deserve a discussion of their own and I just don't have the time for all that now.

Before I wrap up, let me come around and mention those I Savings Bonds again. They really are a great deal compared to the mediocre other bond options. They provide nearly as good a yield as you can find anywhere, they have zero risk from default, complete immunity from losses due to interest rate rises, and you don't have to pay taxes on your gains till you cash out (which you can delay for up to 30 years). You can also use I Savings Bonds as a replacement for an emergency fund! In a pinch, you can cash them after just one year with only a small penalty (which goes away completely after five years). So while your top priority should be maxing out the employer match in 401k plus $5,000 in Roth IRA contributions every year, it's a good idea to keep leftover savings in I Savings Bonds both as an investment and as an emergency fund (you can buy up to $10,000 of I Savings Bonds per year). Sooner or later, as your savings and investments grow, and if the interest rates are still around where they are now, it may make sense to switch your 401k and Roth IRA holdings to be purely in stocks and use your $10,000-per-year I Savings Bonds limit to hold all your bond investments. Just something for you to keep in mind down the road.

Wrap Up

1. Both your friends' suggestion of Wellington+Wellesley or my older suggestion of VTWSX+VBMFX are good. You won't regret going with either one. But you can do better still.
2. Regardless of what you invest in, it is very important to guesstimate (and it is a guesstimate, not a scientifically precise calculation) the mix of stocks and bonds appropriate for your specific situation, your mental makeup, and your financial goals and needs. Bonds are safe but won't grow much. Stocks are not safe but have potential for serious growth. Think of what ratio of them you wish to hold. With 20% stocks + 80% bonds portfolio you'll never lose any sleep worrying about the market -- but the growth will also be glacially slow. 80% stocks + 20% bonds may provide you with much higher returns but they are not guaranteed and your life may become truly miserable if you don't have a strong mental makeup to ignore the inevitable bear markets. Read the my post about selecting the stock-bond mix that I linked and put a lot of thought into this decision
3. Once you decide on your stock-bond mix your best investment choice, in my opinion, is one of the four LifeStrategy mutual funds via a Roth IRA account with Vanguard. These are just excellent, excellent investments that you can hold your entire life and never think about anything else. Pick the LifeStrategy fund that most closely corresponds to your desired stock-bond mix.
4. Separately from LifeStrategy and Roth IRA, check if your employer offers a 401k with employer match. If they do, take full advantage of their match! Once you max out the employer 401k match, make sure you contribute as much as you can to that Roth IRA every year, up to the $5,000 annual limit. Keep channeling all those funds into your selected LifeStrategy account.
5. Finally, if you have savings left over after contributing the minimum required for employer match in 401k and then stashing away the $5,000 in Roth IRA every year, look into I Savings Bonds with TreasuryDirect.gov as both an emergency fund and a very good bond investment. Keeping your bond investment in I Savings Bonds opens up more room in your 401k and Roth IRA for stock investments and currently I Savings Bonds are a very good deal relative to just about every other bond investment.