Many young adults don't take the time to understand how to invest wisely. In many cases, this is because they are concerned about the here-and-now, not the future.
While you don't have to forgo your lifestyle when you are young, taking a long-term focus and investing consistently over a long period of time will ensure that your savings and net worth are there when you need them. In this article, we'll explore the different ways to invest as well as specific tactics for investing wisely.
Ways to Invest
Let's take a look at the most popular long-term investment vehicles you can choose from:
401(k)sA 401(k) is a retirement plan offered by a company to its employees. It allows you to invest on a tax-deferred basis (meaning you don't have to pay taxes on any of the money you put into the plan until you withdraw it). As an added bonus, in many instances, the company will match at least part of the amount that you contribute to the plan.
Young investors should put their 401(k) contributions into an index fund, which is an investment product consisting of many stocks bundled into one neat package, that is designed to mimic the performance of a major stock index such as the S&P 500. Participating in this type of plan means that you will take home a smaller paycheck, because your contributions are deducted directly from your pretax pay. However, you probably won't miss the money as much as you might think; because the contributions are made pretax, most young professionals (who are in the 25% federal tax bracket) will only take home $75 less for every $100 they contribute to a 401(k).
In exchange for this small sacrifice in current pay, you'll experience several important benefits. In addition to the immediate tax savings we just mentioned, you'll also experience tax deferral of all earnings and gains that you make. Also, as long as you invest part of your money in low-risk investments, you can contribute liberally to your plan without worrying about keeping too much money outside of it for emergencies, since it's possible to take a penalty-free loan from your 401(k). Finally, if you decide to leave your current job, you won't lose what you've invested - you can convert your 401(k) into an IRA through what is known as a rollover.
It is important to note that the quality of your investment options can vary depending on your employer. Also, not all companies offer 401(k)s and, contrary to popular belief, the ones that do are not required to offer an employee-matching program. Luckily, this isn't your only investment option.
A 403(b) plan is like a 401(k), but it's offered to certain educators, public employees and nonprofit employees. Like a 401(k), what you contribute is deducted from your paycheck and will grow on a tax-deferred basis; you can roll it all over into an IRA if you change employers. Most 403(b)s will allow you to invest in mutual funds, but others can limit you to annuities. Some will allow you take loans out against the plan, but this option can vary from plan to plan.
Individual Retirement Accounts (IRAs)
There are two types of individual retirement accounts (IRAS): the Traditional IRA and the Roth IRA. These are plans you can contribute to on your own, regardless of whether your employer offers a retirement plan. Both can be opened at a bank or brokerage company and allow you to invest in stocks, bonds, mutual funds or certificates of deposit (CDs). The contribution limits are much lower than what you can contribute through an employer-sponsored plan; in 2012, the IRA contribution limit for those age 49 and under is $5,000, or your total 2012 taxable compensation, whichever is lower.
A Traditional IRA is a tax-deferred retirement account. Much like a 401(k), you contribute pretax dollars, which grow tax free. Only when you begin to withdraw the money will you start paying tax on the withdrawals. Traditional IRAs can have limits on contributions if your modified adjusted gross income (MAGI) exceeds a certain threshold. The earliest age you can start withdrawals is 59.5; if you take the money out before this time, you could be subject to a 10% penalty. Once you reach age 70.5, there are mandatory minimum withdrawals that you must take.
With a Roth IRA, you pay the taxes before you make your contributions. Then, when you withdraw the money during retirement following the rules of the plan, there are no tax consequences. The Roth IRA also has income limitations, but there is no mandatory distribution age and your contributions (although not your earnings) can be withdrawn before age 59.5 without penalty.
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Mistakes to Avoid: Tips and Tactics for Investing Wisely
Achieving success with these long-term investment plans requires that you consistently make contributions, adopt a long-term mindset and not allow day-to-day stock market swings deter you from your ultimate goal of building for the future. To make the most of your earnings when you're young, avoid these common mistakes.
Not InvestingTo many, investing seems like a challenging process. It requires focus and discipline. In order to avoid it, many young investors convince themselves that they can invest "later" and everything will be OK.
What many people don't realize is that the earlier you start putting money away, the less you'll have to contribute. By investing consistently when you are young, you will allow the process of compounding to work to your advantage. The amount that you invest will grow substantially over time as you earn interest, receive dividends and share values appreciate. The longer your money is at work, the wealthier you will be in the future and at the lowest possible cost to you.
Being UnrealisticWhen you are investing at a young age, you can afford to take some calculated risks. That said, it is important to have realistic expectations of your investments. Don't expect every investment to immediately start delivering a 50% return. When the markets and economy are doing well, there are stocks that do have returns like this, but these stocks are generally very volatile and can have huge price swings at any time. By expecting paper losses in bad years and an average return of 8 to 12% per year over the long run, you can avoid the trap of abandoning your investments out of frustration.
Not DiversifyingDiversification is a strategy that will reduce your overall risk by having investments in a variety of different areas. This allows you not be too exposed to an investment that might not be doing so well and helps keep your money growing at a consistent, steady rate every year. Investing in index funds is a great way to diversify with minimal effort.
Letting Your Emotions Drive Your InvestmentsAnother mistake that many investors make is becoming emotional about their investments. In some cases, this means believing that an investment that has done well in the past, like a high-performing stock, will continue to do well in the future. Buying an investment that has a high price because of its past success can make it difficult to profit from that investment. Conversely, many people will sell their investments, or stop making their investment contributions when the markets are down or the economy isn't doing well. This behavior will lock in your losses, hurt your compounding and take you nowhere.
The Bottom LineIt is important to start investing early and consistently to take full advantage of compounding and to use tax-advantaged tools such as 401(k)s, 403(b)s and IRAs to further your goals.
Ignore short-term highs and lows in both the overall market and your individual investments and stay focused on the long-term. By diversifying and remaining realistic and unemotional about your investments, you will be able to build wealth comfortably over time.