Unless you are independently wealthy, setting aside money today to see that you have enough for the years down the road is not an option – it's mandatory. Unfortunately, inertia can be a powerful force and, going from not saving to saving can be daunting to most people. So much investment and financial advice is designed for people who have already begun saving and investing for the future. Therefore, here are some strategies for those looking to starting the process.
Those who earn pay Social Security taxes, but the funds used to pay social security benefits are expected to become depleted in 2035, according to the Social Security Administration. Thus, it is unclear how well its benefits will cover the actual cost of living. Simply consider the debate today over chained CPI and what that could mean to the value of future benefits.
It is also important to note that the government (and many businesses) offers incentives to save. Setting aside money into an appropriate qualified retirement plan (such as an IRA or 401(k)), lowers a tax bill in the year that the money was saved and can accumulate tax-free for decades. Similarly, many companies will also contribute funds if an employee contributes to a retirement account. An employer's contribution amounts to free money and most financial advisors would encourage their clients to maximize this opportunity.
The Challenges in Starting Out
Most people who are not already saving believe that they do not have enough money to meet day-to-day expenses, let alone have any left over to save. However, paying yourself should be every bit as much of a priority as paying other people. Of course it is unwise to default on loans or allow bills to go past due, but if you don't take care of yourself, who will?
There will be months where you come up short and will have little to save. You will also find that your investment choices may be limited. It is important not to become discouraged but to save as much as you can as often as you can.
- The most important step to take in saving for your future is to start saving.
- The government and many businesses offer incentives to save such as IRA or 401(k) accounts.
- IRA or 401(k) accounts allow the account holders to accumulate savings tax-free for many years.
- An employer's contribution to a retirement account amounts to free money, and the benefit should be maximized.
- Brokerage firms should be selected based on the fees charged and their range of ETFs and mutual funds.
The personal-finance industry is set up to cater to those who have considerable wealth—virtually every bank and brokerage would rather deal with 10 millionaires than 10,000 people with $1,000 each. But your savings and retirement plans should not be based upon what meets your needs, not those of the financiers.
To that end, even $250 or $500 in retirement savings is a worthwhile start. Any savings establishes a habit and the process. There are multiple brokers now that offer no-minimum, no-fee retirement accounts. The key to saving for retirement is to be consistent. It should be a continuous, life-long habit.
Thus, it helps to set yourself up for success. For example, don't attempt to scrape together the cash for a last-minute contribution to an IRA in April right before your file your tax return, Instead, save a little each month ideally using an online savings account and only tap into it in extreme emergencies. Most of these online accounts will allow you to automatically deduct a set amount every month from your regular account. If your employer offers a 401(k) program, you can have deductions made automatically from every paycheck.
Selecting a Brokerage Firm
An increasing number of large, national, well-known (as in, "they advertise on TV") brokerage and mutual fund firms are willing to open small accounts without fees or minimums. Opening accounts with these larger firms is a good idea. They often have a wide selection of investment options (mutual funds, ETFs) and the most transparent and reasonable fees. Also, these large firms have the infrastructure to offer you additional services (including personal investment advisers) as your needs change over time.
It is important to take the time to make a good selection. Most, if not all, firms charge fees for transferring accounts, and switching firms repeatedly will reduce your savings. Focus on fees and the range of ETFs and mutual funds that they offer. Do not be too concerned with trading tools and services they offer because trading is not wise when you are saving and have limited funds.
Be Realistic About Risk
Those who are just starting to save for retirement also need to consider investment risk. While academics and investment professionals struggle to define and measure risk, most ordinary people have a pretty clear understanding of it—what is the likelihood that I'm going to lose a substantial portion of my money (with "substantial" varying from person to person)?
I suggest that novice savers and investors be realistic about risk. While any amount of savings is a good start, small amounts of money are not going to produce livable amounts of income in the future. That means that it makes very little sense to invest in fixed income or other conservative investments at the beginning. Similarly, you don't want to destroy that initial savings right off the bat, so avoid the riskiest areas of the market—no biotech, no gold, no leveraged funds, and so on. A basic index fund (a fund that matches a popular index like the Dow Jones Industrials or S&P 500) is a good place to start. There is certainly a risk that the price will fall, but odds of a total wipe-out are nearly zero and favor a reasonable amount of growth.
Your First Investments
As a new saver/investor, your first investments will most likely be in ETFs and/or mutual funds. ETFs and mutual funds allow investors to invest almost any amount of money (from a little to a lot) with little hassle and cost. With a mutual fund or ETF, an investor can take $500 and essentially buy tiny stakes in dozens (if not hundreds or thousands) of stocks all at once giving the investor a greater likelihood of seeing positive returns and fewer major losses.
Index ETFs have become popular in recent years. For minimal cost (an initial commission and a small annual fee that is paid/deducted automatically from the shares themselves), an investor can effectively buy the entire S&P 500 or other popular indexes. A growing number of ETFs that allow investors to invest in broad categories such as "growth" or "value," which is something that has been available to mutual fund investors for decades.
Mutual funds, however, still have their place. Mutual funds often give investors the benefits of active management; that is, a fund manager who makes decisions on a day-to-day basis to try to earn higher returns for investors. By comparison, most ETFs run on auto-pilot—holding a specified list of stocks (usually matching an index) and only changing when the index changes. When looking for mutual funds, determine the fees and expenses (lower is better), and also look at the performance. Ideally, you want a fund that has not only performed well overall compared to its peers, but has lost less money in the bad times.
Regarding first investments, consider two or three ETFs. Most mutual funds have minimum investment amounts of $1,000 or more, so they may not be an option yet. Consider buying a one or two of the following ETFs:
- Vanguard Total Stock Market (NYSE:VTI)
- SPDR S&P 500 (NYSE:SPY)
- Vanguard Dividend Appreciation (NYSE:VIG)
- Vanguard Value (NYSE:VTV)
- Vanguard Growth (NYSE:VUG)
- Vanguard FTSE All-World ex-US (NYSE:VEU)
- Invesco Dynamic Large Cap Value (NYSE: PWV)
- SPDR Dow Jones Industrial Average (NYSE:DIA)
- SPDR S&P Dividend (NYSE:SDY)
- Guggenheim S&P 500 Pure Growth (NYSE:RPG)
If you can afford to own two or three, try to get a good mix. For example, one large market fund (VTI, SPY), an international fund (VEU), and either a growth (VUG, RPG) or value (VTV, PWV) fund based on your personal preferences.
Over time, the habit of saving will hopefully take hold. Moreover, you may find that your earnings increase and that you can save more. As you save more and your initial investments grow in value, you will find that you have an increasing number of investment options.
As you have more money to invest, mutual fund investment minimums may be less restricting, and you may be able to own more funds and ETFs. You may also find that you can afford to take more risks (investing more in growth stocks, or more aggressive-growth equities) or target particular types of investments (investing in specific sectors or geographical areas). If this becomes the case, be careful not to over-diversify. It is much better to have five great ideas than 15 mediocre ideas.
Some readers may be wondering by now when they can start buying individual stocks. There is no hard and fast rule here, but I would suggest that $5,000 in total savings is a good number to use as a minimum. There is nothing wrong with investing $1,000 in an individual stock or two and keeping the rest in funds, or increasing the allocation to individual stocks if you are comfortable.
Investing in individual stocks is quite from investing in funds or ETFs. Investing in stocks requires assuming more responsibility for your investment decisions, which request the investment of considerable time and research. The rewards can be greater, but without the ability to invest the necessary time on an ongoing basis, it is wiser to choose funds and ETFs for the long-term.
As your earnings increase and you have more money left at the end of the month, try to max out your annual contributions to your 401(k), IRA, SEP-IRA, or whatever savings options are available to you. That is, contribute up to the annual maximum allowed by law.
Remember, the government gives you a tax break on your retirement contributions and many employers will match some or all of your contributions. This is "free money" that you won't get otherwise, so it is wise to make the most of it.
Retirement savings in organized accounts such as an IRA is just one type of saving, but there are many more saving options. The government has specific rules and limits on how much you can save each year in tax-sheltered accounts. However, there are no limits on the savings you can put into ordinary taxable brokerage accounts. Although the dividends can be subject to taxation and you will pay taxes on capital gains, you are still saving and building wealth.
It is a fallacy that saving in taxable accounts is not worthwhile because you have to pay the IRS a portion of the profits you make.
The Bottom Line
The most important part of any savings or retirement plan is to simply start. There is no one right way to save money nor one right way to invest. You will make mistakes along the way, and sooner or later you will see the value of some (if not all) of your holdings decline. While this is not desirable, it is normal. What is important, is that you keep saving, keep learning, and keep looking to build wealth for the future. If you establish the habit of saving money every month, take the time to place your money wisely, and patiently allow your wealth to build, you will be taking huge steps forward in making your financial future more secure.