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9 Steps to Financial Freedom (Steps 4-5)

No tricks, no gambles, no far-out ideas. Just nine tried and true, simple but not easy steps to financial freedom for Americans abroad. While I originally wrote this for teachers, the basic financial tenets are suitable for every US expat nonprofit worker, missionary, or limited-income worker. I hope you will benefit from it and take the next step. So, without further ado, here is…

Step #4 Start investing as early as possible

Albert Einstein called compound interest the most powerful force on the planet. Here’s why.

If a 20-year-old future US expat invested $100 a month into an investment account until the age of 65, they would have contributed a total of $54,000 over 45 years. And if they made 10% per year on that money, it would amount to $948,954.38 in an investment account: nearly a million dollars accumulated by a US expat who invested the daily sum of $3.33 per day for 65 years. Even Einstein would have been impressed.

Compare this to a US expat who delays investing until they’re 40 years old. Assume that they allocate $700 a month for the next 25 years. At age 65, they will have invested $210,000 in the market.

Logic might suggest that the person starting later, but investing significantly more, would accumulate a larger account. But the early starter would end up with an advantage of more than $40,000 over the late starter. And they’d achieve their result by investing significantly less money.

Young US expats should understand that the earlier they start investing, the better: money compounds powerfully over time. You don’t need a massive salary to weave a large nest egg; you just need plenty of time and a committed, regular monthly investment plan. You can play with differing scenarios regarding alternative investment returns and their effects over time by logging on to the compounding financial calculator.

Step #5 Invest in Low-Cost Index funds whenever possible

Once a US expat is committed to investing their money for the future, they’re faced with the next inevitable question: Where do I put my money? If you asked the man commonly regarded as history’s greatest investor (Warren Buffett) he’d likely tell you to be wary of the financial service industry and invest in products called “Index Funds” (Janet Lowe, Warren Buffett Speaks: Wit and Wisdom from the World’s Greatest Investor, New Jersey: John Wiley & Sons Inc., 2007, p. 151). A full 92% of American investors buy the index fund’s much more expensive cousin: the actively managed mutual fund (Dick Davis, The Dick Davis Dividend, Hoboken, New Jersey: John Wiley & Sons Inc., 2008, p. 4).

Selling managed funds is more profitable than selling index funds

Selling actively managed mutual funds is more profitable for financial planners than selling index funds is. But index funds tend to perform better and trigger lower taxes than actively managed mutual funds. If you want to read an interesting online article about how the Vice President of Google wanted to ensure that their millionaire employees wouldn’t be taken advantage of by financial planners, check this out: The Best Investment Advice You’ll Never Get. And keep in mind that I am not suggesting that you “go it alone” with your financial planning. There are advisors who can help you to invest effectively, and I will outline how to find one, later in this chapter.

Fees and the Market

Stock market index funds are similar to actively managed stock market mutual funds. For example, Vanguard’s total U.S. stock market index holds thousands of stocks. And generally, nobody trades those stocks. An index is meant to hold a group of stocks, while an actively managed mutual fund is meant to trade a group of stocks. As such, there’s a cost difference that can’t often be overcome. The fees for the average U.S. mutual fund are 600% higher than the fees for, say, a Vanguard U.S. index. It’s a financial albatross that’s tough to overcome with clever trading.

Over a 20 year period from 1978 to 1998, 85% of mutual funds failed to keep pace with the market index—mostly because of their high fee structure. And this 85% failure percentage is conservative because it doesn’t include the poorly performing funds that ceased operations or changed their names when they blended with other funds (F. David Swensen, Unconventional Success—A Fundamental Approach to Personal Investment, New York, NY: Simon & Schuster Inc., 2008, p. 218). Nor does it include the added taxable liability that mutual funds expose their investors to, compared to index funds.

And the 85% of funds that did lose to the markets lost by 3.2% per year over a 20-year study (Arnott, Berkin and Ye, 2000, p. 85-86). If you don’t think 3.2% per year is a large deficit, have a look at what it could do over 50 years:

$10,000 invested at 6.5% per year for 50 years = $233,066.79

$10,000 invested at 9.7% per year for 50 years = $1,024,074.08

The typical professional financial planner, however, (we’ll discuss the atypical planner later) will not invest your money in indexes because index funds don’t pay them as much as actively managed mutual funds. In fact, the largest provider of index funds, the non-profit group called Vanguard, won’t pay advisors a penny. According to Vanguard’s Director of Institutional Sales: “When brokers realize that they won’t be compensated for putting our funds in a plan, they typically hang up on us” (F. David Swensen, Unconventional Success—A Fundamental Approach to Personal Investment, New York, NY: Simon & Schuster Inc., 2008, p. 280).

Now—and this is where Buffett’s argument builds momentum—many advisors who buy these inferior products (mutual funds) for their clients, end up charging them additional sales fees to get into these funds, additional redemption fees to get out, annual “advisor’s fees” amounting to as much as 2% per year—or all three. Again, I’m not suggesting a “Do it yourself” portfolio. Most, if not all of these excesses can be avoided by choosing the right advisor.

Academic studies all suggest that, after all fees and taxes (regular mutual funds cost more money in taxes when held outside of a tax-deferred account), a portfolio of index funds is likely to leave a portfolio of actively managed funds in its dust (Paul B Farrell, The Lazy Person’s Guide to Investing, 2004, p. 151-152).

Taking the Arnott study into consideration, before sales or advisor’s fees, you could end up with a 3.2% annual lag on the return of the market. It’s worth having a look at that difference again:

$10,000 invested at 9.7% per year for 50 years = $1,024,074.08

$10,000 invested at 6.5% per year for 50 years = $233,066.79

Add in an “advisor’s fee” amounting to a further 1% per year (which many financial planners charge) and the chasm widens:

$10,000 invested at 5.5% per year for 50 years = $145, 419.61

US expats might be left with a very important question now: “What if my financial advisor can find mutual funds that can beat the index funds over the long term?” First of all, even if they could, according to the 20 year Arnott study, the mutual funds that have beaten the market indexes only added a further winning margin of 1.3% per year (Arnott, Berkin and Ye, 2000, pp. 85-86).

Secondly, nobody has proven, with consistency, that they can find index-beating mutual funds. It’s easy to find those that have beaten the indexes in the past, but those performances don’t prove to be sustainable. When I personally attended Warren Buffett’s 2005 shareholder meeting in Omaha, he threw a gauntlet to the 24,000 attendees:

“I’ll bet that nobody in this room can name ten mutual funds today that, as an aggregate, will beat the after-tax performance of the S&P 500 index over the next ten years.”

With some of the world’s smartest financial people in attendance, the crowd sat quietly—knowingly. (Note—Buffett tossed out a similar “challenge” regarding Hedge Funds the following year.)

Track record fails
Nobody has proven, with consistency, that they can find index-beating mutual funds

Professor Malkiel created the following scenario to prove the point that it’s practically impossible to find mutual funds that, going forward, will beat the returns of index funds. Imagine that it’s 1980. You have decided to prudently find out which the top performing mutual funds were from 1970 until 1979. And when you find what they are, you buy the best 20 performing funds. Unfortunately, in the decade that followed, you would have (as an average) underperformed—not only the U.S. index but the average U.S. mutual fund as well.

The same rule applied when he assumed that you had bought the top 20 funds of the 1980s. In the decade that followed, they disappointed investors, falling short of the U.S. index. And the 1990s? It was no different. Those funds are disappointing in this decade, drastically falling behind the average mutual fund’s performance and proving to be disastrous when juxtaposed with the total U.S. stock market index (G. Burton Malkiel, A Random Walk Down Wall Street, New York, NY: Norton & Company Inc., 2003, p. 189).

How does this relate to you? What I want to illustrate is the fact that whether you choose your own mutual funds to invest in, or whether you ask an advisor to do it for you, you will very likely lag the results of market tracking index funds. And if you end up lagging the market by just a few percentage points per year, it can have devastating long-term effects on your retirement account.

And if a 3.2% difference sounds dramatic, David Swenson, the superb investor who heads Yale University’s endowment fund, suggests that in a 15 year study, 96% of actively managed mutual funds fail to match the performance of the U.S. market index—by a whopping 4.8% per annum, after all taxes and expenses (David Swenson, Unconventional Success, 2008, p. 217).

There’s a fund rating agency called Morningstar that rates mutual fund performance based on past track records. Then they award them a series of stars—four or five-star funds being the best. If you think you can avoid underperforming the market by doing your own research on top-rated funds, you might want to think twice.

Burton Malkiel’s premise that it’s practically impossible to pick top-performing mutual funds ahead of time holds true in Mark Hulbert’s study as well: “A mutual fund portfolio continuously adjusted to hold only Morningstar’s five star funds earned an annual return of just 6.9% between 1994 and 2004, nearly 40% below the 11.0% return on the total stock market index (John Bogle, The Little Book of Common Sense Investing, Hoboken, New Jersey: John Wiley & Sons Inc., 2007, p. 90).

And don’t forget that you can buy low cost, tax efficient index funds, while being advised by someone charging a fraction of what most other people pay for investment guidance. This strategy is endorsed by Warren Buffett himself when he says, “Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees” (Lawrence A. Cunningham, How To Think Like Benjamin Graham and Invest Like Warren Buffett, New York, NY: McGraw Hill Companies, p. 100). I’ll show you how to do that later in this chapter.

Academics have been shouting this message from the rooftops for years. And adding further insult to injury, more than half of American mutual funds are accompanied by further albatrosses, in the form of sales loads charging fees as high as 6% just to get into them. The chances are high that you actually own some of these yourself. And sometimes, mutual fund companies charge you fees to withdraw money from your funds. These extra costs don’t even go into the underperformance equations I previously cited.

US expats shouldn’t buy mutual funds that charge sales fees. If you pay a fee of 5.75% to get into a fund, then you have to make 6.1% the following year, just to break even. Dr. William Bernstein, who is regularly quoted by The Wall Steet Journal, Barron’s, Money and Forbes, puts it bluntly in his excellent book, The Four Pillars of Investing. Pertaining to sales loaded mutual funds, he goes on to ask, “Who buys this rubbish? Uninformed investors. Who sells it to them? Brokers, investment advisors, and insurance salesmen. Is it illegal? No. But it should be” (William Bernstein, New York, NY: McGraw-Hill Companies, 2002, p. 204). He’s particularly livid about it because the average “load fund” (which is what we call these funds) actually performs worse than the average “no load” mutual fund (Bernstein, 2002, p. 204).

Many of the best financial minds in the country have caught on to the benefits of index funds over all other funds. And it’s evident when examining the biggest pension funds. According to Dick Davis, the Washington State pension fund has 100% of its stock market assets in indexes, the state of California has 86%, New York has 75% and Connecticut has 84% of its stock market money in indexes (Davis, 2008, p. 4). And of the pension funds that aren’t in index funds, more than 90% of them are underperforming an indexed portfolio of stocks and bonds (Bernstein, 2002, p. 86).

This post was originally the chapter “The International Teacher’s Nine Steps to Financial Freedom” in the book Reviving, Retooling and Retiring for Teachers (published by Michigan State University). It was graciously reposted here by Andrew Hallam, public speaker, author of Millionaire Expat: How To Build Wealth Living Overseas, and webmaster of where this post also appears. The word “teacher” was sometimes replaced with “US expat.”  

Andrew Hallam

Andrew Hallam

I’m the author of the best-selling personal finance book, Millionaire Teacher—The Nine Rules of Wealth You Should Have Learned in School (Wiley 2011, 2nd Ed. 2017) and The Global Expatriate’s Guide To Investing – From Millionaire Teacher to Millionaire Expat (Wiley, 2015). My website can be found at

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