How young investors can put together a rock-solid portfolio to benefit from decades of compound interest
It’s one of the biggest tragedies in personal finance. Young investors have a huge opportunity to get started investing, benefiting from decades of growing their money but they don’t know where to begin.
By contrast, older investors may have the extra income and understanding to invest but no longer have time on their side.
We already set up our seven-part series on life-long investing in a previous article, looking exactly how to understand your investing goals and how to match your investor type with investments.
Check out the other articles in the series:
- See how you can invest in your 30s for the right amount of risk and return
- Learn how your investment needs start changing in your 40s
- Find out how to invest in your 50s to balance both safety and growth
- Protect your investments with these pre-retirement tips
- 3 retirement investing strategies to make your money last
In this article, we’ll get started with how younger investors can take advantage of time to reach their financial goals. We’ll follow the three investor types we created in the first article to help you understand your specific needs and how to pick investments with the lowest amount of risk and the right level of return.
Matching your investments with your investor type and by age is one of the most often missed but hugely important issues in investing. All you see on TV is which stocks to pick or where the economy is heading.
None of that matters if you don’t understand your specific needs according to your age, your financial goals and your tolerance for risk.
The investor in their 20s
There are some attributes that will apply to nearly all investors getting started in their 20s. These factors are going to help you understand which specific investments you need in your portfolio while other personal characteristics, which we’ll look at pretty soon, will help you fine-tune your portfolio.
The biggest advantage you have is that of time. Even if you’re planning on retiring early, you’ve likely got at least 30 years before you need to start withdrawing on your investments.
Time is an amazing tool to have on your side. At a 7% return on investment, money doubles every ten years. That means anything you invest today will grow by nearly 15-times over the next 40 years. For investing just $500 today, you get $7,500 to your financial goals!
Of course, the problem is that you probably don’t have a lot of extra money just sitting in your bank account.
The beauty of time is that you don’t need to start with much to make a big impact. Invest just $50 a month for your first ten years investing and you’ll have over $67,500 by the time retirement rolls around…and that’s if you never invest another dime!
Keep increasing your investment savings as you get older and you’ll never have to worry about your finances and it won’t break your budget.
Another attribute shared by younger investors is called liquidity needs. Here, liquidity just means your regular needs for the money. Since you have income coming in, you shouldn’t need to touch your investments.
This is going to change drastically in your 40s when you might need to fund kids’ college costs and later in life when you start living off your investments. For right now, you shouldn’t have a need to withdraw your money.
The flip side to not making much money yet is that income taxes are likely to be low compared to what you’ll pay later in your 30s and 40s. This means you’re not getting quite the tax benefit from some retirement accounts and there’s a better way to invest.
You see, retirement accounts like your company’s 401k and an individual retirement account (IRA) get special tax benefits. You pay no income tax on the deposits you make into these accounts. The money grows tax-free but you can’t touch it until after the age 59 1/2.
When you take this money out then everything, your investment and returns, is taxed as income according to your tax bracket. A retirement portfolio of about $1 million will give you $40,000 a year to live on but you’ll be paying roughly $4,600 in taxes on the current tax brackets after deductions.
By investing in a Roth IRA, a special type of retirement account, you can take advantage of the fact that you aren’t paying much in taxes right now but may owe more in the future. You don’t get that immediate tax deduction on deposits into a Roth account. You pay your normal income taxes on the money.
What you get is money that grows tax-free and no taxes in retirement. When you withdraw your Roth IRA money, you pay no taxes on the money you deposited and never pay any taxes on your earnings.
You should still contribute enough to max out any company match in your 401k plan but consider putting any extra money in a Roth IRA account. You can start a traditional IRA account, where you’ll get that instant income tax deduction, later in your 30s when your tax rate is higher.
Keep in mind that these attributes, characteristics, may be different for your specific circumstances. This is the whole point of making a personal investment plan to find the exact investments right for you.
Thinking about your own specific needs, try to understand how changes in these factors affect your investor type and how much risk you can have in your investments.
- Do you have factors that mean you don’t have as much time to invest as others in your age group? Less time to invest will generally mean you want less risk in your portfolio.
- Do you have irregular or unexpected needs for money from your investments? A chronic medical condition could mean you need to take withdrawals. That or other needs for cash will mean you’ll want less risk in your investments to protect the value of your portfolio.
- Higher taxes from income or your current investments may mean you invest more in tax-advantaged retirement accounts or in tax-free municipal bonds.
Examples of Different Investor Types for Young Investors
We set up our three example investor types in the first article, three hypothetical investors that have different investing needs and will go about reaching their goals in very different ways. The idea is to help you relate to one of the three investors with similarities to your own needs and help understand how you might put together your portfolio.
In this article, all three of our example investors are in their 20s. That gives them all the ability to take on more risk compared to older investors but not necessarily the willingness. A 20-something investor might still want to invest in less risky assets if other risk tolerance factors, which we’ll talk about, mean less willingness.
Conservative Cody doesn’t like risk. He understands that decades to invest means the yearly ups-and-downs of the stock market shouldn’t mean much but the thought of losing thousands of dollars from the money he worked hard to make turns his stomach. He would love to be able to just put his money in an account and not have to look at it or worry about it, even if he doesn’t ‘beat the market’.
Cody is in his late 20s and has a good job but has saved less than $5,000 for retirement. This money is in an investment account but he doesn’t have any other savings or an emergency fund. He doesn’t like his job and wants to retire early at 55 or even younger if possible.
Some things that might make you a conservative investor:
- Having no savings or emergency fund puts you at risk of having to rely on your investments for any unexpected bills. This means you’ll want less risk in your investments so the money will be there if you need it early.
- Your industry or profession is very exposed to the economy and sees frequent layoffs every downturn. You don’t want to risk losing your income at the same time your investments are tumbling in a recession so you might want less risk.
- You may not have as much time to invest as others your age if you plan on retiring early. It may seem counter-intuitive because you want a higher return to grow your portfolio faster but the fact is you won’t have as much time to rebound from investment losses.
Amanda has $12,000 saved for retirement, just under the average for investors between 20- and 30-years old. She’s married and has just started a family but the dual income covers monthly expenses and she’s saving regularly.
She and her husband are covered on her health insurance from work and they have reasonable deductibles on home and auto insurance. She plans on retiring at 65 but could wait until 70 if necessary to meet her retirement goals.
Rebecca graduated with a higher degree several years ago and loves her work. She supposes that she’ll retire at 70 but her entrepreneurial spirit will probably have her doing something even in retirement.
Her salary and modest living expenses have allowed her to already save about $25,000 for retirement. She pays off her credit cards every month and she graduated with little student loan debt. She doesn’t worry about her portfolio value and understands that she’ll probably see several stock market crashes over the next few decades before she retires.
Some things that might mean you can take more risk in investing:
- Few 20-something investors will have much saved up already but already having more than the average of $16,000 shows you are committed to saving. The ability to save regularly goes a long way in being able to take on more investment risk.
- You don’t have to love your job but enjoying your work means you won’t mind working longer. You’re also more likely to do well, earn more frequent promotions and make more money.
- Finally, a willingness to take investment risk and an understanding that investments go down just as well as rise in value.
How to Understand Your Investor Type
You might see yourself in one of these three investor types but take a little time to understand your specific needs. Investing is much more personal than most people understand. Investing according to someone else’s goals and in a portfolio that doesn’t match your personality is the fastest way to lose your path. You’ll take unnecessary risks and make bad investing decisions or you won’t take enough risk and won’t meet your goals.
A few more things to consider to fine-tune your investor type.
- Age has a lot to do with risk tolerance because of ability to take risks. You’ll have a lot of time to see your investments rise but your own willingness to take risk should override it. If you aren’t comfortable losing money in the short-term, stay out of the risky portfolios.
- Check the investment return you need to meet your goal with the return calculator process we talked about in the first article. It’s likely that you don’t need much of an annual return from the decades of compounding interest ahead so can take less risk if you like.
- You may not fully know all your financial goals. You’re just starting to see the reality of family expenses, you may not know what you want to do in retirement and paying for college tuition may seem irrelevant before you even have kids. For this reason, you may want to overestimate your financial needs now to cover expenses that might come up later.
It’s important to review your investor type every five or ten years. If you’re a conservative investor now, you’re likely to stay that way through most of your life but it doesn’t take long to look back through your answers to a risk profile questionnaire and reevaluate. More common is that high-risk investors become more conservative, having invested for return but later wanting to protect their money.
Investing Examples for Investors in their 20s
Once you understand your investor type and how much annual return will get you to your financial goals, you can start to put your money to work in the different asset classes. As we saw in the first article, asset classes are groups of investments that share risk and reward characteristics.
The truth is that you don’t need to pick individual stocks to meet your financial goals. This broad decision of how much to invest in stocks, bonds and real estate will be the most important and will determine how much risk you take and how much return you earn.
The average investor in their 20s is generally going to hold the majority of their portfolio in stocks. Stock investments provide for the highest return over time even if they can go several years losing money due to a recession. For young investors, these short periods of losses shouldn’t matter because they have plenty of time to recover when the economy rebounds.
Stocks also help protect against inflation which is going to be one of the most important needs for young investors. Even at a low 2% annual inflation, your money loses more than half its value over 40 years. That means even the most conservative investor needs to own some stocks and real estate to grow their money beyond growth in prices.
Our conservative investor, Cody, might prefer to hold just 50% in stocks with 20% in bonds and 25% in real estate. The remaining 5% might stay in a cash savings or money market account. The amount held in cash and bonds should give him enough liquidity to pay any unexpected bills without dipping into investments. The diversification in the three assets should help to smooth the portfolio’s value even during stock market crashes.
We’ haven’t talked much about diversification and investing within each asset class but it’s just as important. You have investments within each asset class that are generally safer than others and you can use these to fine-tune your portfolio for as little or as much risk as you like.
For less risk than this 50/20/25 split, you might try investing more of your stock money in sectors like Telecom, Utilities and Consumer Staples. These three sectors have stable revenues and sell things that customers can’t live without. Within your bond investments, you’ll want to invest in high-quality, investment-grade bonds of companies with credit ratings of A- or higher.
That doesn’t mean you want to entirely ignore investing in other sectors within stocks. Lowering your risk as much as possible means spreading your investments across many sectors, you’re just going to be overweighting some sectors. For example, of the nine stock sectors, maybe you hold 15% of your stock money in each of the three sectors above and just 9% in stocks of the other six sectors.
A conservative investment portfolio might look something like this:
You don’t necessarily have to invest in the large, diversified exchange traded funds (ETFs). These funds give you instant diversification across a sector or theme and you can buy them cheaply. It’s really the easiest way to invest because you don’t have to worry about picking the right stock. You simply decide which asset classes and sectors in which you want to invest.
The average investor in their 20s will hold more money in stocks and less in bonds or cash. Our average example investor might hold 65% of their money in stocks, 15% in bonds and 20% in real estate investments.
The investor would probably be more diversified across sectors in stocks as well, investing equally across each sector or just buying the broad market fund. Within bonds, you could supplement the safety of investment grade bonds with some non-investment grade bonds for a little more risk and return.
An average investment portfolio might look something like this:
Our investor that doesn’t mind more risk, Rebecca, will weight most of her portfolio to stocks with something like 70% in stocks, 15% in bonds and 15% in real estate. Within stocks, she’ll overweight growth sectors for higher returns. These are sectors like Technology, Materials, and Healthcare that might have less stable revenues but generally grow faster than other parts of the economy.
Within her bond portfolio, Rebecca might overweight non-investment grade bonds and may even invest some money in peer-to-peer lending. Peer lending is basically the same as investing in bonds except they’re loans to other people instead of to corporations. The risk is higher and closer to stocks but you can expect annual returns of 6% to 10% and risks can still be managed. I have just over 5% of my total wealth in peer loans on Lending Club.
A higher-risk, higher-return portfolio might look something like this:
Investment Returns for Each Investor Type
I’ve used the ten-year returns on each of the funds above along with the percentage allocations to estimate an annual return for each investor. Your actual return, even on these exact percentages, will differ from year-to-year but the idea is that it averages out over the longer-term.
You’re going to find that the estimated return difference for each investor is fairly small, just 1.3% separates the conservative portfolio from the risky investments. It’s a bigger difference than it may seem though and the difference in risk is even bigger.
The conservative portfolio of 50/20/25 and 5% in cash would have produced an annual 6.9% over the last decade. The portfolio produces solid cash flow from the bonds and real estate as well as the heavy investment in utilities and telecom stocks. Even though this is the most conservative of the example portfolios for young investors, it should still produce a strong return well over that of other conservative investment strategies we’ll look at for other investor ages.
The increased investment in stocks and high-yield bonds bumps the expected return to 7.7% annually for the average investor. Instead of investing across all the sector funds, you could put your stock investment in the S&P 500 SPDR ETF (SPY) which invests automatically across all the sectors.
Increasing your investments in stocks and putting money in peer loans further increases the expected return to 8.2% for the higher-risk portfolio. Even though this is the riskiest portfolio for the age group, it’s still fairly well-diversified. You’ll have to expect large swings in the value during stock market crashes but the investments in bonds, p2p loans and real estate will still smooth it out.
Closing Summary and Action Steps
This is probably your first opportunity to invest and the first time you have to really think about long-term financial goals. Take your time to think through what you want from your money and your investing needs. Following this series and the process throughout different life-stages will help keep you on track to reach your goals and then some.
- Understand the advantages and characteristics of investors in their 20s such as years to retirement, low tax rates, expenses that might change with a growing family and changing life goals.
- Understand how your own situation, especially your willingness to tolerate risk, fits with these general factors.
- Determine your investor type depending on the above factors.
- Estimate an expected return from a mix of stocks, bonds and real estate depending on your investor type. Be sure to include the various sectors and different types of bond and real estate funds to spread your investment risk.
- Revisit your investment plan every five to ten years to make sure it still matches your need for return and risk tolerance.
Investing in your 20s is a huge opportunity. Compared to most investors, you can take more risk and have much longer to see your returns start adding up. Even if you are only able to scrape together $50 a month, you have the opportunity to see it become hundreds of thousands over the next few decades. Don’t wait to put together a portfolio of investments, whether based on one of the example portfolios above or one from your own favorite funds.