When it comes to personal finance, saving and investing, the caveats "it depends" or "your situation may be different" come up a lot. But that's not the case with economic retirement planning. Unless you are one of the very fortunate few to be independently wealthy, setting aside money today to see that you have enough for the years down the road isn't 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. Making matters worse, so much of the investment and financial advice out there is designed for people who've already crossed the Rubicon and started saving and investing for the future. What we hope to do here, then, is outline some strategies for starting the process.
Hopefully anyone who is reading this column is already on board with the idea that saving money is not an optional exercise. Nobody knows what Social Security will look like in a decade or more, nor how well its benefits will cover the actual cost of living. Simply consider the debate today over using chained CPI and what that could mean to the value of future benefits.
It's also important to note that the government (and many businesses) offers incentives to save, and it's silly not to take advantage of them. If you set aside money into an appropriate qualified retirement plan (like an IRA or 401(k)), you not only get a lower tax bill in that year, but the money you save can build up tax-free for decades. Likewise, many companies will kick in some funds if you make a contribution to a retirement account; this is free money from your employer that you won't get otherwise, so do what you can to maximize this.
In my experience, one of the biggest problems people encounter when they try to start saving is the belief that they don't have enough money as it is, let alone any left over to save. While I don't mean to appear to be lecturing those who are legitimately struggling to get by, I do believe that too many people ignore the fact that paying yourself should be every bit as much of a priority as paying other people. I'm not suggesting defaulting on loans or letting bills go past due, but if you don't take care of yourself, who will?
It's also important to just accept from the beginning that there will be challenges as you start. There will be months where you come up a little short and don't have as much to save. You will also find that your investment choices are pretty limited and that many people won't want to deal with your money because there's not much of it. Don't be discouraged – save as much as you can as often as you can.
It is absolutely true that 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 they want or what's convenient for them, but rather what meets your needs.
To that end, even $250 or $500 in retirement savings is a worthwhile start. Any savings is savings, and saving even relatively small amounts of money establishes the habit and the process. There are multiple brokers now that offer no-minimum, no-fee retirement accounts and you can get $25 or $50 deducted from your account every month and sent into that retirement account. Sure, this isn't going to buy you a villa in France for your retirement, but you are establishing good habits and you ARE saving.
At the risk of harping on this, it really is important to look at this as a non-stop, life-long habit. It can be tricky to scrape together the cash to make a last-minute contribution to an IRA in April, right before your file your tax return, so don't set yourself up for failure. Save a little each month, ideally using an online savings account and only tapping 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, and if your employer offers a 401(k) program, you will be able to have deductions made automatically from every paycheck.
As I said before, more and more of the 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. By and large, I do believe going with these larger firms is a good idea. They often have the deepest selection of investment options (mutual funds, ETFs, etc.), the most transparent and reasonable fees, and the infrastructure to offer you additional services (including personal investment advisers) as your needs change over time.
Make sure to take the time to make a good selection. Most, if not all, firms charge fees for transferring accounts and you don't want to whittle away your money by switching firms repeatedly. Don't worry about firms that boast of the tools they offer traders; you won't be trading that much. What you should instead focus on is low fees/commissions and a wide selection of mutual funds and ETFs.
Those who are just starting off saving for retirement also need to think about 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 chance 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 right at the beginning. Likewise, 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's certainly a risk that the price will fall, but odds of a total wipe-out are nearly zero and the odds favor a reasonable amount of growth.
As a new saver/investor, your first investments will most likely be in ETFs and/or mutual funds. ETFs and mutual funds are very useful as they allow investors to invest almost any amount of money (from very little to quite 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 better chance of seeing positive returns and fewer major losses.
Index ETFs have rightly become very popular in recent years. For very little 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. There's also a growing number of ETFs that allow investors to invest in broad categories like "growth" or "value" – 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 living, breathing fund manager who makes decisions on a day-to-day basis to try to earn higher returns for investors. By comparison, most ETFs run basically 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, then, make sure to look at the fees and expenses (lower is better), but 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.
As far as those first investments go, 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. In any case, consider buying a couple of the following ETFs:
If you can afford to own two or three, try to get a good mix – say, 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.
As time goes on, the habit of saving will hopefully take hold. What's more, as time goes on 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 more and more investing options.
As you have more money to invest, mutual fund investment minimums may no longer matter as much, 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). Be careful not to over-diversify, though. 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's 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.
Just remember that investing in individual stocks is quite a bit different than investing in funds or ETFs. You have to take on considerably more responsibility for your investment decisions; it takes considerably more time; and takes quite a bit more research to select and invest in individual stocks. The rewards are certainly there, but unless you are willing to devote a meaningful amount of time on an ongoing basis, you may find that sticking with funds and ETFs makes more sense for the long-term.
As you have more money to invest, you should also make sure you're maxing out your opportunities. We started off talking about saving even just $25 a month, but 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 these contributions and many employers will match some or all of your contributions. This is "free money" that you won't get otherwise, so do what you can to make the most of it.
It's also very important to remember that retirement savings in organized accounts like an IRA is just one type of saving. There is no rule out there that says you can't save more than this. The government does have fairly specific rules and limits on how much you can save each year in tax-sheltered accounts, but there are no limits on the savings you can put into ordinary taxable brokerage accounts. Yes, the dividends here can be subject to taxation and you will pay taxes on capital gains, but you're still saving and building wealth – don't ever fall into the trap of believing that saving in taxable accounts is somehow a waste of time or money just because you have to pay the IRS some of the profits you make.
The most important part of any savings or retirement plan is to simply start doing it. 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. This is normal; it doesn't feel particularly good, but it is normal. What is important, though, 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, taking the time to find good homes for that money, and patiently allowing your wealth to build, you will be taking some huge steps forward in making your financial future more secure.