Investing by age series: Investing in your 20s
Author: Peter Lazaroff
The financial decisions you make in your 20s are arguably more important than any other time in your life.
The most important decision you can make is to start now. To illustrate, imagine two college graduates with access to tax-deferred investment accounts earning 8% per year. The first investor saves $250 a month for ten years (for a total of $30,000) and then doesn’t make another investment for the next 30 years. At the end of the 40 years, their portfolio amounts to $509,605.
The second investor doesn’t invest for the first ten years of the same 40-year period. Instead, they contribute $250 a month for the next 30 years for a total contribution of $90,000. But despite saving more money over a longer period of time, the second investor ends up with only $375,074.
This goes to show that the most potent combination for wealth creation is time and the power of compounding. Whether you’re saving early and often, systematically adding to your investment portfolio or staying the course in times of uncertainty, time has the power to turn small habits into incredible results.
With that in mind, here are the most important things you should do in your 20s:
Before investing, it’s important to understand what you want to do with the wealth you create. Creating a reverse budget is a good framework for setting goals and establishing a plan to meet them.
Savings for short-term goals of less than five years should be kept in cash rather than invested in the stock market. Market volatility is inevitable – it’s the cost of higher expected returns in stocks versus bonds or cash – so it’s unwise to accept the risk of market losses for your short-term goals because they have less time (and sometimes no time) to recover.
While savings for short-term goals should be in cash, a mix of stocks and bonds are essential to growing your wealth to fund long-term goals like retirement or a child’s college tuition. If your portfolio lacks sufficient exposure to riskier assets like stocks, then you may not generate enough returns to meet your long-term goals. A portfolio that doesn’t take enough risk will also require an unrealistic savings rate relative to your cash flow.
Max out your retirement accounts
There are a variety of retirement accounts that offer tax-free compounding of earnings, income, and capital gains. The best place to start is investing enough in your employer-sponsored retirement plan to earn a match. For example, if your employer has a 3% match and your salary is $100,000, you’ll need to contribute at least $3,000 to your retirement plan to be entitled to your employer’s full matching contribution. Failure to make this contribution is like leaving free money on the table.
Put aside money for a rainy day
Having money available for unexpected expenses, regardless of your financial position, is extremely important. In fact, allocating some portion of your excess savings to an emergency fund takes priority over extra debt repayments or additional investing.
In general, an emergency fund should contain three to 12 months of expenses. If your emergency fund is starting from zero, then allocate at least 10% of your excess savings each month to this account. If you have a high degree of job security and income predictability, then you can probably build this account up more slowly.
Consider keeping your emergency fund in an online account to earn a higher interest rate than you would in your primary checking account. As an added bonus, keeping your emergency savings separate from your primary checking reduces the temptation to access those funds for non-emergency purposes.
Don’t try to beat the market
Investing is a complex activity, but that doesn’t mean it requires a complex solution. The problem is that most investors get in their own way by unnecessarily meddling in their portfolios.
While it’s natural to want investments that beat the market, most investors taking this route underestimate the competition they face and the opportunity for success.
There is an overwhelming amount of research showing that both individuals and professional investors routinely underperform the market, but that doesn’t mean you shouldn’t invest. Instead, it simply suggests a passive investment strategy will improve your chances for success.
Make it automatic
Finances have a way of getting increasingly complicated as you age. Putting your savings, bills and investments on autopilot can simplify things.
For your investments, automating a dollar-cost averaging (DCA) plan removes the need for determining the best time to invest by regularly contributing a set amount to your portfolio. For example, you could contribute $1,000 to an investment account on the 15th of the month for a long period of time. This allows you to diversify not only across asset classes but time. Making equal dollar purchases over time can potentially lower your average purchase prices because you buy fewer shares when prices are high and more shares when prices are low.
While a lower average purchase price isn’t always guaranteed, DCA is still behaviorally advantageous because investing at regular intervals reduces the risk of buying at the worst times and experiencing an immediate loss in value. DCA is also the simplest way to invest paycheck to paycheck. You don’t have to do anything beyond setting up automated monthly contributions to your accounts.
Start making these changes now. The good decisions you make early in life will have more time to compound in your favor and set you on the path for financial success.