This article was originally published on Bankrate.com by Brian Baker.
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Millennials haven’t had it easy. Growing up, the generation born between 1981 and 1996 experienced the attacks on Sept. 11, subsequent wars, the worst recession since the great depression, a student loan crisis and a global pandemic. It’s understandable why they may not have had saving and investing for retirement at the top of their minds.
But with most millennials done with school and having worked for at least a few years, many are at an age where they can and should start thinking about investing and how it can help them achieve long-term financial goals.
Let’s take a look at some investing basics and why it’s important to get started.
Why it’s important for millennials to invest
If you witnessed the 2008 financial crisis, you may perceive investing as risky, but not investing carries risk, too. “The worst thing you can do in your mid-20s to mid-30s is not save money and invest. If you invest money early on, it gives your money a long time to grow,” says Mike Kerins, founder and CEO of RobustWealth. He says that in spite of the ups and downs of the market, it’s rare that the stock market stays down for a long period of time.
Stock investments deliver bigger returns over cash and bonds in the long run. Money sitting in savings accounts is stagnant and subject to rising inflation, whereas stock market investments can compound over the years. More specifically, large capitalization stocks returned roughly 10 percent compounded annually from 1926-2020. Over that same time period, long-term government bonds returned only about 5.5 percent annually and T-bills returned around 3.3 percent annually.
“The surest way to build wealth over long time horizons is to invest in a diversified portfolio of common stocks,” says Robert Johnson, professor of finance at Creighton University and chairman and CEO of Economic Index Associates.
The other advantage of investing money over time is that it creates a snowball effect. “Millennials need to begin compounding early and let that compounding work its patient magic over decades,” Johnson says. Compounding means that when you earn interest on your investments, you also earn interest on that interest. This allows you to build a larger and larger balance over time — even without extra capital investment.
For example, if you invested $6,000 per year when you were 25 years old, and earned $100 that year in interest, at 26, you’d earn interest on $6,100, then on $6,300, then on $6,600, and so on. Over the years, you’d have a significantly larger return than if you just deposited that money in a savings account or hid it under the mattress.
Educate yourself on the basics:
- Risk tolerance: Before making your first investments it’s important to understand your risk tolerance. Risk tolerance refers to your ability and willingness to handle investment losses, which might be temporary or permanent. While the stock market tends to rise over the long term, it can and has experienced severe declines over shorter time periods. You’ll want to think about whether you have the stomach to stick it out during those periods of decline, or if you might be better off in safer investments.
- Asset allocation: As you develop and build your investment portfolio, you’ll need to determine how much of it should be allocated toward stocks versus other assets like bonds or real estate. Assets can even be broken down further into buckets based on geography, investing style or type of company. This mix is referred to as your asset allocation and will likely shift from being mostly risky assets early on in your investing life to safer assets as you move into retirement age.
- Active vs. passive: Another key decision you’ll need to make is whether you want to be a passive or active investor. Active investors attempt to beat popular market indexes such as the S&P 500 by investing in companies they think will outperform. Passive investing, sometimes referred to as index investing, seeks to match the performance of the broad indexes and is available to investors at very little cost. This cost savings has generally meant that passive investors have outperformed active investors over long time periods.
- Diversification: Put simply, diversification is the financial equivalent of the old adage, “Don’t pull all your eggs in one basket.” By diversifying, you’re spreading your assets across several different assets, recognizing that some will do well and others will do poorly. Broad diversified portfolios have performed well over time.
- Time horizon: Knowing your time horizon is a critical step in any financial plan. Identifying key goals, whether it’s saving for retirement or a child’s education, will have a big impact on how you invest. Long-term goals — at least five years away — will typically result in owning long-term assets such as stocks. Short-term goals such as saving for a down payment on a house will be better served by investing in safer assets such as a high-yield savings account.
Learn the types of accounts:
- IRA: An individual retirement account, or IRA, is an account that will allow you to save for retirement while offering some meaningful tax advantages. Money contributed to an IRA will be allowed to grow tax-free, allowing you to compound at a higher return than if you paid taxes along the way. You contribute funds pretax, which could lead to a lower tax bill today. Withdrawals can begin at age 59 1/2, at which point you’ll pay taxes on the money you take out.
- Roth IRA: While similar to a traditional IRA, a Roth IRA has some key differences. Money contributed to a Roth IRA is done so after taxes are paid, so there’s no immediate tax benefit. But when withdrawals begin at age 59 1/2, you won’t owe any taxes. The Roth IRA is one of the best vehicles to save for retirement because of this big tax advantage. Keep in mind that early withdrawals from both Roth and traditional IRAs will usually come with a 10 percent penalty.
- 401(k): A 401(k) is one of the most popular workplace retirement plans. The plan allows employees and employers to set aside a portion of earnings to be invested for retirement. Many employers offer to match what employees contribute up to a certain amount. This match is important to take advantage of because it’s almost like free money from your employer. Contributions are allowed to grow tax-free, but withdrawals, which typically begin at age 62 or 63, will be taxed.
- Brokerage: A brokerage account allows you to invest in securities such as stocks, bonds and ETFs. Brokerage accounts are taxable, which means you’ll pay capital gains tax on any realized gains in this type of account. If you’re already maximizing your retirement savings through accounts like 401(k)s and IRAs, a brokerage account can be an additional way to build wealth over time. Many online brokers offer free trading commissions and you’ll be able to access your money penalty-free whenever you’d like.
Best investments for millennials:
- Stocks: For millennials, most investing goals will be long-term goals such as retirement, which will be best accomplished through owning long-term assets like stocks. A stock is a partial ownership interest in a business and over time, the stock will perform similarly to the way the underlying business performs. You can invest in stocks by purchasing them individually or through ETFs and mutual funds.
- Index funds: Index funds are mutual funds or ETFs that seek to match the performance of an index such as the S&P 500 or the Dow Jones Industrial Average. Index funds can be used to invest in stocks, bonds or even real estate. Because index funds are passively managed, they typically have very low costs, which leaves more of the return for investors. Index funds are a great way for investors to build a broad diversified portfolio while paying very little or nothing in fees.
- ETFs: Exchange-traded funds, or ETFs, is a type of fund that holds a basket of securities, but trades throughout the day similar to a stock. You can invest in stock ETFs, bond ETFs, commodity ETFs and countless others. Many ETFs are passive and track indexes such as the S&P 500 or the Russell 2000. ETFs can be a great way to build a diversified portfolio even if you don’t have much money to invest. Unlike mutual funds, ETFs typically don’t have a minimum investment.
- Mutual funds: A mutual fund is a pool of money from investors invested in a group of securities such as stocks or bonds. Your investment in the fund will be invested in the same way that the overall fund is invested, so if the fund has five percent of its assets in Microsoft, your investment will also have five percent of its assets in Microsoft. Unlike ETFs, mutual funds only trade once a day and investors transact at the closing NAV price, or net asset value. Mutual funds can be purchased through a broker or through the fund company itself and typically have a minimum investment of a few thousand dollars. It’s important to note that a fund’s returns will only be as good as those of the underlying assets the fund is invested in. Mutual funds and ETFs are the vehicle for investing, but your return will be determined by the assets, such as stocks or bonds, the fund holds.