Young investors today who wish to begin a savings plan face a bewildering array of investment options. There are not only thousands of products and services to choose from, there are almost as many different firms and vendors that market them in various capacities. Fortunately, deciding which types of investments are best is not as hard as it may seem.
Saving for Retirement
If you are young, your greatest financial asset is time—and compound interest. At this point in your life, your primary investment objective for your long-term savings should be growth. Investors in their 20s will have at least 40 years over which to accumulate retirement savings.
Historical data clearly shows that common stock and real estate are the only two asset classes that have grown faster than the rate of inflation over time.
This means that most or all of your long-term savings should probably be placed in some form of equities, such as individual common stocks and stock mutual funds—and perhaps real estate, either in the form of a personal residence or a mutual fund that invests in real estate holdings, called a REIT. It is imperative to be able to increase your purchasing power in your retirement savings over the course of your life because you will need every penny you can muster after you stop working.
401(k)s and IRAs
IRAs and employer-sponsored retirement plans are the best places to start when saving for retirement. Employer-sponsored plans often provide matching contributions, and this can give your retirement savings a tremendous boost; a 50% match on the first 5% of your contributions can result in tens of thousands of extra dollars in your pocket at retirement.
Most financial experts tell young people to use a Roth IRA instead of a traditional IRA because– although you don't get a tax benefit from your contributions – both your contributions and everything they earn will grow tax-free until retirement and you won't pay any tax on withdrawals.
Roth features are also available in many qualified plans such as 401(k) plans. Money in traditional IRAs and 401(k)s is taxed at your personal income tax rate when you withdraw it at retirement – and you are required to withdraw a certain amount, starting after age 70½, whether you need it or not. Ultimately, the Roth combination of tax-free growth (and no required withdrawals) coupled with the superior returns posted by equities is virtually impossible to beat over time.
- Young investors have the single most valuable resource on their side—time. Compound interest and dividend reinvestment are proven methods of building long-term wealth. This is how Warren Buffett made his fortune.
- Day-trading looks like a desirable lifestyle and can indeed yield above-market returns, but most investors who utilize this strategy lose their retirement accounts entirely.
- It is nearly impossible for individual investors to beat the market over a long period.
- Real estate can be a solid investment choice if the investor will stay there for longer than five years.
- IRAs and 401(k)s are extremely good investment choices if your employer will match.
Buying a Home
Traditional financial wisdom has usually dictated that a house is one of the best investments you can buy, but whether or not this is true depends upon several variables. The duration of your residence and the current housing market will factor heavily into this issue, as will the current interest rate environment, rental prices, and your personal financial situation.
If you plan on living in one place for less than five years, it is probably cheaper to rent in most cases because, mathematically speaking, it usually takes at least five to seven years to accumulate enough equity in a home to justify buying one rather than renting.
Saving for College
If you are still trying to get through school or have not yet started, then there are several other vehicles for you to consider socking money into:
529 Plans: Every state has this type of college savings plan that allows you to put money away for higher education. (Actually, it now covers K-12 private education, as well, but that likely won't be your problem.) The funds can be allocated among various investment choices and will grow tax-free until they are withdrawn to pay for qualified higher education expenses. The contribution limits for these plans are quite high and they can also provide gift and estate tax savings for wealthy donors looking to reduce their taxable estates.
Coverdell Educational Savings Accounts: This type of college savings account is another option for those who want to take a more self-directed approach to choosing their investments. The annual contribution limit is currently $2,000 per year, but it may still be a viable alternative if you want to purchase a specific investment that is not offered inside a 529 Plan.
U.S. Savings Bonds: These are yet another alternative to consider for conservative investors who don't want to risk their principal. The interest that they earn is also tax-free as long as it is used for higher education expenses.
The alternatives for your short-term cash, such as an emergency fund, are pretty much the same regardless of your age. Money market funds, savings accounts, and short-term CDs can all provide safety and liquidity for your idle cash. The amount that you keep in these investments will depend on your personal financial situation, but most experts recommend keeping enough to cover at least three to six months of living expenses.
Young investors should understand that over a long period of time such as their working years, investing in ETFs that track the market and letting dividends and interest build almost always beat a short-term stock trading strategy. Although returns can be high, most day-traders bust within a year. Worst case scenario they lose their entire principal, and can even end up owing their brokerage interest on margin trades.
The Bottom Line
The most important decision that you can make as a young person is to get into the habit of saving regularly. What you invest in matters less than the fact that you have decided to invest. The right investments for you are going to depend largely upon your personal investment objectives, risk tolerance, and time horizon.