In our previous article, we discussed a few fundamental concepts on investing in index funds, as a simple means to putting your money to work for you. There are plenty of technical write-ups online written by those who enjoy financial analysis for further education, but this guide helps cut out technical details that are not necessarily critical for those limited on time.
As physicians, we are well-versed in technicalities in our field. There is no doubt that if you dedicated as little as one hour of your week to learning further about investing fundamentals that you will likely be more attuned to the terminology and principles in 6 months than most of your colleagues. If you have the motivation and time, this is a good subject to familiarize yourself with. If not, then you can still get your feet wet and manage well with what is discussed in this series.
Index investing is not a get-rich-quick strategy
For whatever reason, doctors are willing to put in a whole lot of effort with little return frequently in our daily lives. Prior authorization calls, utilization management calls, walking specimens over to the pathologist so it doesn’t get lost…many of these activities are for the benefit of our patients, but rarely translate into direct benefit for ourselves. This scut is implicit in our job description, so that’s why we deal with it.
On the other hand, it is quite frequent that I hear physicians bantering about strategies to earn a lot of money with little effort. Who doesn’t want that? Just as the survival rate for Stave IV pancreatic cancer is so dismal, the get-rich-quick schemes are so few and far between that no one should realistically think that wealth will magically present itself. You have to work for it.
Index fund investing ranks high on the list of investment modalities that yield relatively well with little effort. Since most broad market index funds are tied to the economy, it is likely (but not guaranteed) that any economic downturn that would affect the performance of these funds will also affect most other alternative investments.
The S&P500 Index, which consists of a collection of stocks that are considered to reflect the overall health of the stock market, has returned an average of 10% (before inflation) since its inception in 1926. Any index fund that tracks the S&P500 performance will likely return a similar (but lower) annual return as the index itself. Conservatively, you can expect to get a 7% annual return on this fund. This means that your initial investment may take roughly 10 years to double.
That’s not bad for minimal work, and significantly better than keeping your savings in a bank account losing value to inflation.
Tax efficiency of stocks
Most physicians’ marginal income tax brackets are going to be in the 30% or higher. State tax will add on another 5% to 12.3% (Californians pay the price).
Most alternative income streams other than through stocks are taxed under these income tax rates. What this means is that profits from real estate rentals are going to be taxed at your marginal rates. While each investment strategy may have its own tax deferral strategies (depreciations and 1031 exchanges come to mind in real estate), you will eventually need to pay the tax man if you are going to turn a real profit unless you intend to pass your dealings to your heirs.
Profits from gains in stocks are much simpler. A stock sale is categorized as a short-term capital gain if you held the asset for less than one year, or a long-term capital gain if you held it for longer. Short-term gains are taxed at your the marginal tax rate like your regular work income. Long-term capital gains are taxed at either 0%, 15%, or 20% on profits depending on your annual income.
While it’s clear that stocks confer tax advantages, it is also important to remember that you only pay taxes on the amount that a stock/fund has gained. Given that you’re expecting roughly a 7% annual return on these index funds anyway, the goal of investing is to buy and hold for the long term.
Reassessing the goal of index fund investing
With any investment, it is important to acknowledge the expected risks and returns. It is also important to determine what your investment horizon is, and how easily you need to access your investment.
It is not uncommon that someone at the local hospital talks about a new high-interest money market account that pays 10x of the current average savings account. Too bad that it still only amounts to 0.60%. Nonetheless, these options are perfectly reasonable if the goal is to have liquidity in the short term for a mortgage down-payment or to have a temporary holding account until you decide where to invest for the long term.
Likewise, it doesn’t matter how great an investment is if the window of return is beyond what the investor is comfortable with. Index stock funds are an interesting investing modality, because the outcomes are highly predictable:
- Investment horizon is long.
- Profits are stable but not necessarily life-altering.
You are definitely going to be inflation with index fund investing, and it also won’t get you out of bankruptcy.
In the next article, we will discuss some of the technical details of finding a custodian and making an investment.