9. Investing in Your Twenties
If you’re starting your career or have recently graduated from college, the financial choices you make now can have a bigger impact on your future financial security than those you make at any other time of your life.
You don’t necessarily have to sacrifice a lot to have a big long-term impact. Even modest sums invested regularly in growth investments, such as a well-diversified portfolio of stock, stock mutual funds, or ETFs have the potential to increase to a substantial nest egg over 25 or 30 years or more.
There will be competing pulls on your money if you’re paying off student loans or helping your parents or younger siblings with their expenses. And, if you’re just starting out on your own, you may be finding it difficult to make ends meet.
On the other hand, you’re probably not paying off a large mortgage and home repair expenses or dealing with the costs of raising a family. You probably don’t have major healthcare expenses. In addition, if you have a job you like and you’re good at, it’s reasonable to expect that your earnings will increase.
Benefits of starting early
Having time ahead of you gives you other advantages. Few people are able to come up with the money they need to meet major expenses—such as buying a home or sending children to college—out of their ordinary income. But by planning ahead and making small but regular contributions to your investment accounts, it becomes easier to accumulate the sums you’ll need. If you have the money automatically deducted from your paycheck or checking account, you may never even miss it.
Plus, the longer you have to invest, the greater the potential for your investments to compound, or grow in value. Compounding is what happens when your investment earnings or income are reinvested and start generating earnings themselves. To see how this works, compare the following two individual retirement accounts (IRAs):
| Investor A’s portfolio | Investor B’s portfolio | |
| Monthly investment | $150 | $300 |
| Length of investment | 40 years | 20 years |
| Total investment | $72,000 | $72,000 |
| Annual interest rate, compounded yearly | 9% | 9% |
| Total value of account at end of investment period | $667,637 | $202,434 |
Investor A begins investing $150 a month in an IRA when he’s 25. Investor B, on the other hand, doesn’t start investing in an IRA until she’s 45, although she contributes twice the amount of Investor A, or $300 per month. When they turn 65, they’ve both contributed the same amount of money to their accounts, or $72,000, and both have earned an average annual rate of return of 9%, compounded yearly—a realistic average rate of return for a diversified stock portfolio.
But while Investor B has $202,434 in her account by age 65, Investor A has $667,637 in his account—over three times as much. The difference is that he started much earlier, and his account had 20 additional years to compound.
The debt dilemma
If you have little credit card debt or only a small student loan to repay, you’re in an exceptionally good position to start investing. But if you’re carrying a high balance from month to month on one or more credit cards, it’s probably a good idea to make paying off your high interest debt a priority, even if it means you’ll have to invest less at the beginning—or even have to put off investing altogether for a while.
That’s because if you own a stock mutual fund that earns, say, an average of 8% per year, but you’re carrying consumer debt on which you pay 17% annual interest, then you’re actually paying more percentage-wise in interest than you’re earning on your investments. If you’re in a situation similar to this, it may be the one circumstance when it makes sense to postpone your investing plans and instead concentrate on paying down your high-interest debt.
On the other hand, if you have loans with low interest rates, it may make sense to pay them off over time while you pursue your investing strategy rather than postponing investing until you’re debt free. The interest on some student loans is a good example, since it may be lower than the market rate on other loans, or lower than what you could earn from certain investments. Depending on your income, you may also qualify to deduct some or all of student loan interest payments when you file your federal tax return, which could have the further benefit of lowering your current income taxes.
Easy to get started
As you take the first steps toward contributing to a 401(k) or opening an IRA, you may feel overwhelmed by the decisions you have to make. But it’s important to keep in mind that you don’t have to resort to complex investing strategies or products to succeed as an investor. The tools you need to build the foundations of future financial security are simpler than you think.
If you’re not sure where to start, consider investing in a balanced fund that provides a mix of investment-grade bonds and stock, or a large-company stock or index fund that invests in all of the securities included in the market index it tracks. Or, if you want to put your retirement savings completely on auto-pilot, you can also consider a life-cycle fund that makes and adjusts investment allocations based on your target retirement date. If that date is a long time from now, the lifecycle fund will be more heavily weighted toward stocks or stock mutual funds. But as the date approaches when you will need your money, the investment mix will become weighted more heavily toward fixed-income or stable value investments, including bonds or bond funds and Treasury securities.
As your confidence develops, you can start branching out into other categories of investments that can help you diversify your portfolio. These might include international funds that invest in overseas companies, small-company and emerging growth funds, corporate and government bond funds, and ETFs or individual securities that you can invest in through a brokerage account.
If you need help choosing among different funds, you might ask the bank, brokerage firm, or investment company that handles your account to put you in touch with an investment professional who can point you to appropriate investments. Make sure to review all the investment literature you receive carefully, including any fund prospectuses and research reports, before committing your money. You’ll also want to be sure that the investment, whether it’s an individual security, a mutual fund, an ETF, or some other type of investment product, fits in with your overall asset allocation and diversification strategy.
Getting an early start is key. Once you start making regular contributions to meet long-term goals, you’ll be seeding a portfolio that has the potential to grow for the rest of your working life.
Growing your portfolio with growth investments
You can increase the potential for compounding in your long-term investment portfolio by emphasizing growth investments. Unlike cash equivalents, which tend to provide predictable though modest income, growth investments can increase significantly in value over time.
Stock, stock mutual funds, and stock ETFs may all be classified as growth investments. But some stock and stock funds are more growth-oriented than others. For instance, the stock of larger, well-established companies—also known as large-capitalization stock—tends to grow in value more slowly than other types of stock and the price usually doesn’t fluctuate as dramatically.
At the other end of the spectrum is small-company stock—also known as small-capitalization or small-cap stock. While over longer periods of time small-cap stock as a group has historically produced stronger returns than any other investment category, small caps can be extremely volatile. This means that the prices of the individual stocks in this category can fluctuate dramatically in value from year to year as well as day to day.
Because you probably won’t be drawing on your retirement assets for several decades, it’s worth considering investing a portion of your retirement portfolio in small-cap stocks for the extra growth potential they offer. Many employer sponsored retirement plans such as 401(k)s offer small-cap stock funds or funds that seek aggressive growth among their investment choices. You can make similar investments in an IRA of your choosing.
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