When it comes to investing, time is your friend.
The more time your money is invested, the more time it has to grow. The beauty of investing is you earn interest on the interest you’ve already earned on your initial investment — a concept known as “compound interest.” Legendary scientist Albert Einstein reportedly once said that compound interest is “the eighth wonder of the world” and “the most powerful force in the universe.”
A calculation done by the Federal Reserve Bank of St. Louis highlights the winning math behind compounding. An investor who starts saving at age 25 and invests $5,000 a year for 10 years in a row and earns 8% per year would accumulate $787,180 by age 65. In contrast, someone that begins investing 10 years later at age 35 and sets aside $5,000 a year for 30 years would have just $611,730 at age 65.
It’s like a snowball effect. The longer you are invested the more you benefit.
There’s a big difference between saving and investing. Investing is about taking some risk to reap higher potential returns.
Large U.S. stocks, for example, generated compound annual returns of 10% in the 93 years ending in 2018, according to Morningstar. In contrast, a 20-year government bond returned 5.5% per year and 30-day Treasury bills gained 3.3 per annum. During that period, $1 invested in large stocks grew to $7,030, versus just $142 for the long-term bond and $21 for the Treasury bill.
Historically, investing in the stock market outperforms having your money sitting in cash.
If you just landed a job and your employer offers a 401(k) retirement plan, make sure you enroll. It’s an easy way to regularly sock away money that you’ll need when you stop working decades from now.
One benefit of a 401(k) is you’ll automatically have a portion of each paycheck go directly into your retirement savings plan, which offers a menu of diversified investment options to choose from. Since contributions in a traditional 401(k) are made with pre-tax dollars, you’ll also lower your tax bill. Another plus is most employers also contribute to your 401(k) via matching contributions.
The first thing I would do as a young investor at a new job is to find out exactly what the 401(k) plan offers, (and) what the match is.
Ideally, you want to contribute enough to your 401(k) to be eligible for the full company match.
The average company match was 4.7%, a Fidelity study found last year. The company match is like getting an extra paycheck sent to your retirement account.
No clue how to pick the right stocks or mutual funds? Or how to build a diversified portfolio? Don’t worry about it.
Most 401(k) plans offer “target-date” funds. These funds do all the work for you. They pick the individual investments like stocks and bonds, as well as make sure your holdings are diversified and not too risky for your age.
Target-date funds are a great place to start.
Here’s how these funds work. You pick a target year that’s closest to the year you’ll think you’ll stop working. For example, you’d invest in a “2050 Fund” if you plan on retiring 30 years from now. As you move closer to your retirement target date, the fund will lower your fund’s risk profile by reducing the percentage of more volatile stocks and shift the money into safer investments like bonds and cash.
Rather than having to pick individual funds and decide how much you want to contribute to each one all by yourself, they do it for you.
What you don’t want to do is put off saving until tomorrow. To avoid procrastination, set your long-term investments on autopilot.
Automate your investments. If you aren’t already saving automatically in your 401(k) via payroll deductions at work, set up a system where money is taken out of your checking account and moved into your investment account on a predetermined date each month.
It forces you to save, and takes the emotion out of investing, adding that automatic savings also removes the temptation to try to time the market, or get in and out at precisely the right time, which is difficult.
Think Tesla will dominate the electric car space forever? Well, even if you do, don’t invest every penny of your money in Elon Musk’s company.
Why? If you’re wrong and Tesla’s stock tanks, you won’t have anything else in your portfolio to cushion the financial fall. The concept of owning a wide variety of investments is known as diversification. Your much better off investing in funds that own many stocks in different businesses or a variety of interest-paying bonds to spread your risk around.
Diversification doesn’t mean guaranteed returns or no volatility. The idea is to smooth out the ride.
Try to determine your maximum pain threshold, or how big a loss you can endure without bailing out of the market at the wrong time.
The biggest mistake beginners make is forgetting that it is a long-term investment. New investors may immediately see their account values fall, get nervous, and sell their investments. Patience is key.
To gauge your true tolerance for risk, follow this exercise: Imagine you had $100,000 invested in stocks and the market fell and your account balance fell by $30,000. How are you feeling? Are you losing sleep? Do you not really care? If a potential loss of that size stresses you out, it’s signaling that you might need to trim the risk in your portfolio.
A good rule of thumb is to try to save 10% to 15% of your pay in your retirement plan. (Include any company match in calculating your savings rate.)
If you can’t save that much at the start, gradually increase your savings annually.
Some 401(k) plans have a feature known as ‘auto-escalation,’ where you agree today to save more tomorrow and your company’s plan will automatically increase the portion of your paycheck deducted each year.
Turn off the financial news. Bears warning of a market meltdown might spook you out of the market at the wrong time. And bulls predicting that the market will double might make you overly optimistic and vulnerable to a big selloff if you go all in.
A big mistake beginner investors make is taking what’s said by others as gospel.
And if you just don’t feel comfortable getting started on your own, ask for help.
A lot of investing can be done independently, but not everything in your life can be do it yourself.
You can get help from a financial planner or advisor, an accountant or lawyer, or people in your life that have success managing money.
