Young investors can take advantage of time and avoid making the most common mistakes by following these five rules
George Bernard Shaw once said, “Youth is wasted on the young.”
He probably wasn’t talking about investing…though maybe he should have been.
When I was just starting out investing in my early 20s, I didn’t have a clue about asset allocation or how to invest on a life-long plan. I chased stocks just as I chased girls.
I lost money in stocks…my experience chasing girls will have to wait for a different article.
There’s no better opportunity in investing than starting young. You have the power to grow your portfolio over decades and earn a higher return than those of us with a lower tolerance for risk brought on by fewer years to retirement.
That benefit of youth doesn’t have to be wasted on young investors.
Following just a few simple investing rules will help you put together a strategy for long-term gains and that avoids the biggest problems.
Young Investors Can Take More Risk
Imagine you have been saving for retirement for 35 years, and you’re planning to use that savings to pay your bills next year.
What would happen if your investments lost a significant chunk of their value? It might force you to change your lifestyle.
But what if you were just starting to save and didn’t need to touch the money for 35 years? Chances are a dip in value wouldn’t impact you in the short term and, over time, the market might not only recover but could move higher before you need to access your savings.
When you select a mix of stocks, bonds, and cash for your investing strategy – part of the decision you have to make is how much risk you can take. If you are saving for retirement and have decades before you stop working, you may be able to take on more investment risk as part of your diversified portfolio.
But why would you want to take on risk? Well, while stocks have historically been more volatile than bonds or cash, they’ve also delivered larger returns.
As a young investor, you may be able to better tolerate that volatility than an older person. After all, you have time on your side. So, while past performance is no guarantee of the future, that time gives you more opportunity to cash in on stocks’ potential for growth.
Understanding your investing risk tolerance is the first step in building out your investment plan and critical to find the best investments for your needs.
Start Investing Early and Make Your Money Work Longer
Investing young also means having more time for your investments to be in the market.
That puts the power of compounding on your side.
Let’s look at a simple hypothetical example of how compounding works. In this example, we will see how $200 grows with a 7% return that compounds each year.
How compounding works…
Over time compounding can have a major impact on your savings. Let’s say a hypothetical investor was trying to save for retirement and had $5,000 they could put into a retirement account each year.
It’s the same money each year but starting earlier means a huge difference in how much you have on which to retire!
The graphic assumes a $5,000 annual deposit and 7% returns in a tax-advantaged retirement plan. We saw how these retirement accounts were nearly free money and as close to beating the market as possible in a prior article.
The bottom line: Starting on the right path as a young investor can help put you in a position to choose the kind of lifestyle and experiences you want to enjoy later on.
One of my favorite ways to start investing, highlighted in a previous article on best ways to invest $1,000 now, is through a Lending Club account and peer lending investing. P2P investing gives you the returns of stocks but on lower risk because you’re investing in loans. You can earn a modest 6% annual return even in the safest category of loans, a return that can mean a huge payoff over several decades.
So what should you do to best achieve your financial goals? Here’s a few tips for young investors that will help you get the most from your money.
1) Contribute at least enough to get any matching contribution for your 401(k) or other workplace savings plan.
If you have access to a 401(k), 403(b), or 457 retirement savings plan and your employer offers a matching contribution, take advantage of it. The matching contribution is like getting “free” money. And you get the added potential benefits of any tax-deferred growth and compounded returns.
2) Pay down high-interest debt.
I hate to hear people recommending paying off debt before you start investing. Shopping is too much fun and you may never be totally debt free. You will need to retire someday though and your investments better be ready.
That said, put extra money to paying off high-interest debt on credit cards. Start with at least $50 a month investing if you are still paying down debt but prioritize anything with an interest rate of 10% or higher.
3) Fund a traditional or Roth IRA.
When you’ve maxed out your 401(k), consider other investment choices such as a Roth IRA. If you don’t qualify for one because of your income, a traditional IRA might be another option. The annual IRA contribution limit for 2011 is $5,000. To make it easy, set up your IRA contributions to be automatic, as they are for 401(k)s.
Splitting your investment into both a traditional and a Roth IRA is a great strategy for increasing your retirement income. You’ll get immediate tax benefits from the traditional IRA and will get tax-free money in retirement from the Roth account.
Don’t complicate investing as a young investor. With 30 or 40 years to retirement, you don’t need risky investments and double-digit returns. Gambling for these kinds of returns is only going to waste the opportunity you have in investing early when the market falls out from under your portfolio. Follow these three investing rules and invest each month to beat your goals.