Millennials often think they are too young to get serious about investing for retirement. The truth is, with the majority of their earning and saving years ahead of them, young people actually have the most at stake when making investment decisions. Any mistakes are compounded over a long lifetime of investing, so it is extremely important for young people to set themselves up for retirement success from the very beginning.
As a Millennial who works as a retirement planner, I think about this issue a lot. In the interest of helping my peers start off on the right foot when investing for retirement, below are my seven key recommendations for Millennials who are just beginning their investment journey.
1. Save As Much Possible, As Early As Possible
It is important for Millennials to save as much as they can in their early years to enable their invested savings to compound over decades. To understand the math of compound stock returns, let’s put them in perspective using the rule of 72. The rule of 72 is a “back of the envelope” approximation of how long it takes an investment to double in value provided a certain interest rate, calculated by simply dividing that interest rate into the number 72. (For more, see: Retirement Savings Tips for 25- to 34-Year-Olds.)
The average return of the S&P 500 has been just over 10% since 1926. Applying the rule of 72 to a 10% return implies funds invested in the stock market take roughly 7.2 years to double. That does not mean your money doubles every 7.2 years. There have been entire decades where the stock market went practically nowhere. But over long periods of time, this is approximately how the math works out.
A 29-year-old Millennial has already been around long enough for this “doubling” to happen four times. One dollar invested at the beginning of their life turned to two, then to four, then to eight, and finally doubled once more to be worth around $16 today. But keep in mind, the typical Millennial will likely invest over a period at least twice as long going forward. Their invested dollars could potentially double up to eight times. That means $1 invested grows to $256. Sounds astronomical, but that’s just the math of compounding. Moral of the story, the earlier you invest your money, the longer compound interest has to work its magic for you.
2. Invest Retirement Savings in Stocks
Millennials should invest 100% of retirement savings in stocks. Stocks as an asset class have a higher expected return than bonds or cash over long periods of time. This higher expected return is compensation for taking on the short-term unpredictability of stock returns. In any given year stocks can easily decline 20% or 30% (or even 50% in extreme cases). Bonds and cash don’t do that, and therefore provide a lower return over long periods of time.
Because of the short-term unpredictability of stock returns, it is helpful to have a long time horizon when investing in stocks. Fortunately, Millennials do. Most Millennials have over 30 years until retirement, which is a long enough time horizon that you can be confident you will end up better off with stocks. Add another 30 years in retirement, and the typical Millennial will actually be investing over (at least) a 60-year time horizon - a very long time to benefit from the compound growth of the stock market. Any money invested in cash or bonds is missing out on this growth of the stock market, which compounded over 60 years can be substantial, to say the least.
For this reason, I recommend Millennials invest any funds designated for retirement in 100% stocks using low-cost, diversified mutual funds and exchange-traded funds (ETFs). But a word of caution. You will notice I specified to invest in 100% stocks with money that is designated for retirement. Nobody knows what will happen with the stock market in the short-term, so if you have a large financial goal (such as a down payment on a house) on the horizon within the next few months or years, or are setting aside money for an emergency fund, the money has no business being invested in stocks. (Read more, here: How Much Millennials Should Save to Retire Comfortably.)
3. Use Tax-Advantaged Accounts
Tax-advantaged retirement accounts enable you to turbocharge your retirement savings, if you follow all the rules. Traditional 401(k) and IRA contributions can be deducted from taxable income, which results in a tax savings today. The funds can then grow tax deferred until withdrawal at full retirement age. You will, however, be taxed on your contributions and earnings in the account upon withdrawal.
Alternatively, you can contribute to a Roth 401(k) or Roth IRA with after-tax dollars. While there are no tax savings for doing so today, funds in the accounts grow tax deferred, and can ultimately be withdrawn tax free at full retirement age. But remember, you usually must wait until age 59 ½ to withdraw from IRAs without penalty, or age 55 with separation of service for 401(k)s, though there are some exceptions that allow you to access that money earlier without penalty. A final piece of advice on tax-advantaged accounts: don’t over think it. The Roth versus traditional IRA decision can help you out, but it won’t make or break a retirement. People sometimes get lost in the decision of Roth versus traditional and because of that never actually end up investing in either.
4. Set It and Forget It
The best approach to build wealth over the long run is a simple buy and hold approach. Leave your investments alone, minus tweaks to rebalance back to your target portfolio weights. There are costs involved in making switches in your investment portfolio and too much activity serves as a drag on your investment portfolio return. I think a great metaphor for an investment portfolio is a bar of soap - the more you handle it, the less of it you will have. Never bail out of your investments during a temporary decline. You won’t need to sell your investments anytime soon, so stock market declines are just a temporary sale on the things you intend to buy anyway.
5. Keep Costs Low
You receive the return of your investments minus your costs of investing. It is simple arithmetic that high costs reduce returns and have a negative impact on your portfolio, so it is in your best interest to keep costs as low as possible. Costs show up in many forms. One of the easiest to identify is the expense ratios on your investment funds. Expense ratios have come down across the board over the years, as investors have become increasingly sensitive of costs. It is fairly common to see expense ratios for simple index funds as low as 0.10% and even lower. But there are still plenty of higher-cost options (over 1%) out there that should be avoided. Most of the time in life, you get what you pay for. There is often a value to be gained from paying more for something. This is not the case with investments. You do not need to pay extra to be successful. It is actually wiser to pay less.
It is important to spread your money around to as many different countries, industries or companies as possible. This prevents the poor performance of any single country, company or industry from taking down your entire investment portfolio and retirement goals with it. It is also important to diversify to ensure you actually receive the return of the stock market and grow your wealth over time. The performance of the stock market as a whole is driven by a relative few star performers. Though it may be tempting to try to pick the star performers in advance, there is no way to predict who they will be ahead of time. The only way to ensure you own the star performers that drive the returns of the stock market is by owning everything, all the time.
7. Create a Financial Plan
All of your investment decisions should be driven by the purpose for your money. A financial plan will spell out how much you should save and how you should invest to achieve your retirement goals. Even Millennials with few assets can benefit from a written financial plan. Considering any mistakes will be compounded over a long lifetime of investing, young people have the most at stake with financial decisions and can benefit even more from a financial plan than their older counterparts. (For related reading, see: What Makes Millennial Savers Unique?)