If you are in your early 20s and able to save for retirement, then you are well on your way to building a nest egg that may allow you to retire early and comfortably. However, it is important for younger savers to elect appropriate investments for themselves given their age, income and willingness to undertake market risk. Let's take a look at some of the investment selections that are likely to make the most sense for younger savers.
Risk and Reward
Once you have joined the workforce and you have successfully saved the recommended emergency cash fund, you can start to focus on funding your retirement account. As a 20-something, you enjoy the luxury of working for another 40 years or so, which means that your savings have much longer to grow versus somebody in their 30s or 40s. Due to this longer amount of time, you are able to take on a bit more risk while you are in your 20s. Alongside greater risk comes the potential for greater reward in the form of higher returns. Therefore, the amount of money that you allocate to riskier assets such as equities should be highest when you are younger.
Allocating to Equities
To determine how much of your retirement savings should be invested in equities, many people simply subtract their age from 100. If you are 20, then 100 minus 20 equals 80. So, at least 80% of your retirement savings should be allocated towards equities. Funds that are not allocated to equities should go into investment grade corporate bonds or cash.
Which Equities Should I Choose?
The equities selected for a retirement account depend largely upon the type of account in which retirement assets are being housed. In many people's cases, retirement assets are held in an employer's 401(k) or 403(b) plan. These plans are limited to a few handfuls of investment options that typically include mutual funds. A mutual fund may contain a blend of stocks, bonds and cash. Many retirement plan options also include equity-only mutual funds, bond-only mutual funds and targeted retirement date funds. Therefore, it is important to understand what the components are of each fund. This information can be found on a fund's fact sheet or within its prospectus.
Targeted date retirement funds are an interesting option for 20-somethings because they take much of the work out of the mutual fund selection process. Essentially, the allocation of the fund is adjusted as you get older, which means the mutual fund would be heavily weighted towards equities while you are in your 20s but heavily weighted towards cash and bonds while you are in your 70s. Many targeted date funds are named with the intended retirement date. For example, the Vanguard Target Retirement 2050 Fund would be suitable for somebody who plans on retiring in 2050.
When it comes to making investment selections for an IRA, you may enjoy a bit more flexibility. Within most IRAs, you are able to invest in most mutual funds. You may also be able to invest in individual stocks and bonds that may not be available in 401(k) and 403(b) plans. If you decide to build up your equity exposure on your own, keep in mind that not every piece of equity is created equal. Foreign equities and small- or mid-cap equities tend to be much more volatile than large-cap U.S. equities. Other asset classes such as commodities or real estate can add meaningful risk to your retirement portfolio.
The Bottom Line
As a 20-something, you are able to take on more risk than a 40-something. Most people take on risk by investing in equities. How you obtain this equity exposure depends upon the type of account being used for retirement savings. An employer's 401(k) or 403(b) plan offers several suitable investment options, while an IRA may offer even more flexibility. Prior to making any selections, be sure to read up on your investment options so that you can be well-informed regarding your investment. If you have a financial advisor, be sure to consult with him or her.