We all know that investing is one of the best ways to grow your money, but many young adults don’t know how to start and are afraid they don’t have enough money to invest. The truth is, you do not need thousands of dollars to start investing, and with today’s advancements in investment technology, there are many easy ways to start the process. The more you save and invest today, the better your financial future will look. So, why not start investing in your 20s?
Here are some tips to get you on your way.
Why Invest When You Are Young?
The key to financial freedom for the future is to invest when you are young. By getting your personal finances on track at a young age, you will have time on your side. Saving and investing in your 20s, even if you can only invest a little, is better than investing a large amount when you start earning big later in life.
That is because of compound interest and compounding returns. In addition to earning returns on the money you invest, you also earn returns on those returns. This means your money grows at an increasing rate. In other words, the earlier you start saving and investing, and the longer you leave your investments untouched, the faster your money will grow because compound interest and returns grow exponentially over time.
Let’s look at the following example that shows that waiting 10 or 20 years to start investing can make a huge difference in the end balance at retirement:
Consider investing $300 each month into a Roth IRA (after-tax individual retirement account) starting at the ages of 25, 35, and 45 to retire at 65:
With a 6% rate of return:
Age 25: End Balance: $572,303 (total contributions $144,000)
Age 35: End Balance: $292,354 (total contributions $108,000)
Age 45: End Balance: $136,032 (total contributions $72,000)
With an 8% rate of return:
Age 25: End Balance: $966,324 (total contributions $144,000)
Age 35: End Balance: $422,565 (total contributions $108,000)
Age 45: End Balance: $170,700 (total contributions $72,000)
With a 10% rate of return
Age 25: End Balance: $1,665,104 (total contributions $144,000)
Age 35: End Balance: $618,853 (total contributions $108,000)
Age 45: End Balance: $215,478 (total contributions $72,000)
This shows that time is on your side when you are investing in your 20s because compound returns make your money grow at an increasing rate.
The example shows that a small investment of $300 per month at the age of 25 with an expected 8% return rate will give you $966,324 at retirement. In contrast, starting the same investment strategy 10 years later at the age of 35, at the same expected return rate of 8%, the amount you end up with at retirement is only $422,565. This means that the extra $36,000 ($144,000 – $108,000) in contributions made between the age of 25 and 35 will result in an extra $543,759!
Now take the example with an expected return rate of 10%, and compare the end balance of starting to invest at age 25 with the end balance of starting to invest at age 45. When investing $300 monthly for 40 years, at a 10% return rate, your end balance at age 65 will be $1,665,104. In contrast, starting the $300 monthly contributions 20 years later at 45, your end balance at age 65 will only be $215,578. This means that the extra $72,000 ($144,000 – $72,000) in contributions made between the age of 25 and 45 will result in an extra $1,449,626!
Compounding happens when interest or returns are paid repeatedly. The results of the first few cycles are barely noticeable. However, after getting interest payments or returns repeatedly, the balance shows exponential growth, and the results become impressive. The higher the frequency of compounding, the more dramatic the results are.
So getting started with investing in your 20s is a big deal. The longer your money is invested, the more opportunity it has to compound over time. Every day you delay saving or investing is a day you miss the opportunity to start compounding and get you on your way to living the life you have always dreamed of.
Start an Emergency Fund and Prioritize Financial Goals
Investing in your 20s is very important, but so is creating a stable financial foundation. So, before you start investing, it is crucial to make your minimum debt payments on time to avoid negative marks on your credit report and decrease your credit score. Then, start saving for emergencies, pay off high-interest debt, and create a long-term financial plan.
It is essential to build an emergency fund to ensure you are covered when an unexpected event such as a job loss or a natural disaster occurs. It will be best if you never have to rely on your investments as a safety net, as investments might not be easily accessible. The general rule is to have between 3 to 6 months of expenses in cash available in a high-yield savings account. Contribute to your fund regularly until you have reached the amount that you are comfortable with.
While you are saving for your emergency fund, you should also assess your debt situation. Many 20 somethings have debt, mainly from student loans and credit cards. Investing when you have debt might not seem like the best idea, but that really depends on what type of debt you carry.
Not all debt is evil. There is good debt, and there is bad debt. Good debt can be used as leverage and a tool to increase income. Good debts are long-term loans that are greater than 10 years, are used for something that increases your net worth or income, are within your budget, and can increase your credit score. Most mortgages and student loans meet these criteria.
Bad debts are usually debts that are not planned, not within your budget, have a high interest rate, and do not increase your net worth or income. Bad debt should be avoided when possible. In many cases, paying down your debt should be prioritized in your 20s, especially when it involves high-interest debts such as credit card debt, store credit, and cash advances.
In the end, it comes down to this: What is the most optimal usage of your next dollar? Follow these steps, and you will be on your way to a worry-free financial future.
- Always make your minimum debt payments on time
2. Maximize the match in your employer-sponsored retirement plan
3. Pay off high-interest debts such as credit card debts
4. Build your safety net/emergency fund
5. Save for your retirement (401(k), IRA in tax-advantaged retirement accounts
Set Savings and Investment Goals
Once you have started your emergency fund, you can start creating your investment goals and strategy to reach those goals. Make a list of all your goals and then prioritize them in different “time-period” buckets:
Short-term: The short-term goal bucket is where you will keep the funds that you think you will need within the next 1 to 5 years for things such as travel, a down payment on a house, or a wedding. The best place to put the short-term money that you need in the next couple of years is somewhere easily accessible and not subject to market fluctuations. Examples are high-yield savings accounts, money market accounts, and CDs. With the money you will need in 3 to 5 years, you can buy bonds and stock market options that you can liquidate short-term.
Mid-to-long-term: The money you do not need for the next 5 to 20 years, you can invest in medium- to long-term investment accounts that expose you to more risk but higher returns. Open a low-cost brokerage account or a Robo advisor account where you can invest money in a combination of stocks, bonds, mutual funds, index funds, ETFs, and other asset classes.
Long-term: This investment bucket is for funds that you will not need for at least 20 years. This bucket will include your growth assets, and although growth assets can be vulnerable to big swings in the short term, they will provide you with consistent portfolio growth over the long run. Moreover, it can be used to generate funds for your main long-term goal, retirement.
Contribute To an Employer-Sponsored Retirement Account
If you are employed and your employer offers an employer-sponsored retirement savings plan such as a 401(k) plan, you definitely should participate in it. This plan allows you to contribute regularly by automatic payroll deduction, either a certain amount of money or a certain percentage of your income up to a maximum yearly amount. Contributions are invested in funds that employees select from a limited number of investment options offered by the employer. Mutual funds are the most common investment options offered in a 401(k), although some plans also offer exchange-traded funds (ETFs). The annual contribution limit for 2021 is $19,500, with a $6,500 catch-up contribution for contributors over 50.
The biggest advantage of a 401(k) plan is when an employer/company will match part of your contribution. This is a pretty common practice. For example, your employer might offer a dollar-for-dollar or 50-cents-on-the-dollar match, up to a certain percentage of your contribution. Essentially this employer match is free money for you, and everyone should take advantage of this and contribute at least the amount that the employer matches.
Another huge advantage of a 401(k) plan is that contributions are pretax, which means that income tax on this part of your income gets deferred until you make withdrawals during retirement. Besides, you pay no taxes on any investment growth, as long as the money remains in the account. This means no taxes on gains, interest, and dividends.
So taxes on contributions and investment growth are not due until you start making withdrawals during retirement. Your income during retirement will often be lower than when you were working, which might result in a lower income tax bracket. Withdrawal before the age of 59 1/2 should be avoided at all costs because besides owing income tax on that money immediately, you might also incur a 10% tax penalty unless an exception applies. Examples of exceptions are withdrawals used for certain medical expenses or higher education.
Contribute To a Traditional or Roth IRA
Another way to fund your long-term financial goals when investing in your 20s is to open an individual retirement account or IRA. There are two main types, the traditional IRA and the Roth IRA. The benefit of traditional IRA accounts is that the funds grow tax-free until the time of your retirement. This is advantageous because this makes your investments grow faster because of compounding returns. Besides, you might be in a lower income tax bracket during retirement. This makes traditional IRAs ideal for long-term growth.
The annual contribution limit for a traditional IRA for 2021 is $6,000, with a $1,000 catch-up contribution for contributors over 50. Please be aware that there are limitations on withdrawing the funds from a traditional IRA account before retirement. Income tax will be due at the time of early withdrawal (before 59 1/2), plus a 10% penalty tax will be charged for non-qualified withdrawals. There are exceptions for not having to pay the penalty. A traditional IRA also has Required Minimum Distributions (RMDs) starting at age 72.
The traditional IRA uses pre-tax money to save for retirement, while a Roth IRA uses after-tax money. During retirement, you will pay taxes on your traditional IRA contribution withdrawals. However, you can make tax-free withdrawals from the Roth IRA account because you have already paid income tax on your contributions. Another advantage of a Roth IRA is that it has no required minimum distributions.
Open a Low-Cost Online Brokerage Account or a Robo-Advisor Account
For some of your non-retirement longer-term financial goals such as a down payment on a home or your children’s college expenses, brokerage accounts are great options.
There are 3 common types of brokerage accounts:
Full-service brokerage accounts connect you to a dedicated professional financial advisor who knows you and your financial situation and selects investments based on your financial goals. Because young investors usually do not have a lot of money to invest, and full-service accounts are expensive, they are probably not the best option for new 20 something investors.
The other 2 types of brokerage accounts available that are a better fit for young investors are online self-directed brokerage accounts and Robo-advisor accounts. They have no or low minimum investment requirements and are low or no-cost.
Online discount self-directed brokerage accounts such as E*Trade or TD Ameritrade accounts can be a great option if you are knowledgeable and comfortable enough to make sound investment decisions amongst an almost unlimited number of investment options. You should also make sure that you have enough discipline to give a self-directed account the kind of attention it requires. This type of account involves no or low commissions and fees and gives you complete control of your investments.
These days, many self-directed brokerage accounts also offer educational tools to help you make guided decisions. With these accounts, you are in control, and you decide what assets to put in your portfolio. You can build your own portfolio by using their online app or their website.
Robo-advisor accounts are another type of brokerage account. They are a great option for new investors or investors that do not have the time or interest in making investment decisions. Robo advisors are investment management companies that rely on computers rather than financial advisors to build and manage your portfolio. These companies offer low fees, low minimums, and a plethora of educational resources for new investors. The whole process is pretty simple. You create an account online, and you provide information about your financial goals, risk tolerance, and time horizon. Then you fund your account, and computerized algorithms will create the ideal portfolio that matches your needs and goals.
Robo-advisors even reinvest dividends, rebalance your portfolio periodically, and offer tax-saving strategies on your investment gains. Dependent on your age and personal goals, they typically invest in a mix of stocks, bonds, ETFs, and sometimes Real Estate Investment Trusts (REITs). Costs for a Robo-advisor account are low. If you want to go the Robo-Advisor route, the more well-known ones are Betterment and Wealthfront, and both have an Assets Under Management (AUM) fee of only 0.25% per year.
Understand the Different Asset Classes and Their Risks
Investing is a tradeoff between risk and reward. Higher risk usually gets rewarded with higher returns. When you invest in your 20s, you should be aggressive with your investments because time is on your side.
As a beginning investor, the most common asset classes to invest in are stocks and bonds, so it is crucial to understand the differences between these two asset classes are. Here is a quick overview of the main differences.
When you purchase stocks in a company, you become a part-owner of that company. You will get a proportional share of the profits and losses, depending on the business. You also run the risk of the stocks becoming worthless if the company or business shuts unexpectedly.
When you buy an index fund, you spread your risk because you purchase a representation of a basket of stocks designed to track a certain index. Examples of indexes are the Dow Jones Industrial Average or the S&P 500 index. Over the long term, index funds have generally outperformed other types of mutual funds. Index funds also offer low fees, tax advantages and are highly diversified. A disadvantage of index funds is a lack of flexibility. Another negative is the lack of possible huge returns as the fund merely tracks the index and does not try to outperform the market.
Bonds are debt instruments that are issued by the government or corporate entities. When you buy a bond, you are lending money to the issuer. In return, the issuer promises to pay you a specified rate of interest during the life of the bond and to repay the principal when it matures or comes due after a set period of time. Bonds do not appreciate like stocks do, carry lower risk, and have a lower return rate. Bonds seek to mitigate risks that are carried with stock and normally offset the stock market dips. In other words, if you are looking for a steady income while preserving your principal, bonds are the ideal choice.
As a general rule, it is better to invest in funds, baskets of securities, such as mutual funds, Exchange Traded Funds (ETFs), and index funds, than in individual stocks or bonds as it spreads the risk among all the companies in the fund instead of just one company.
Each investment comes with its own set of risks, and most investments do not guarantee returns. However, the earnings when investing young are considerably higher than the earnings when starting investments at an older age.
Create a Portfolio That Fits Your Age and Your Risk Tolerance
A diversified portfolio is critical to a successful investment strategy because it reduces volatility by spreading the risk. Having the right mix of stocks, bonds, and other investment vehicles to meet your long-term financial goals is crucial. The general belief is that the younger you are, the more risk you should take with your long-term investments. However, you should definitely consider your risk tolerance level when you start building your portfolio.
The main difference between an aggressive (higher risk) and a conservative (lower risk) portfolio is the balance between stocks and bonds. So what is the best asset allocation for long-term investments for someone in their 20s? The general rule of thumb is that you should follow the 120 rule if you are an aggressive investor. This means that you should subtract your age from 120, and that’s the percentage of your portfolio that you should keep in stocks.
So, for example, if you’re 30, you should invest 90% of your portfolio in stocks. If you’re 60, you should keep about 60% of your portfolio in stocks. Young people can load up on risk because they have plenty of time to recover from downturns in the market. If you are a more conservative investor or closer to retirement age, you might want to follow the 100 rule. This means you should subtract your age from 100. So, this rule tells you that if you are 60, you should invest 40% of your assets in stocks.
However, not every young investor feels comfortable taking that much risk, and that is ok. You can start with a portfolio with a 60% stock allocation with the remainder in bonds and keep that mix for a while to experience the ups and downs of the market. Once you become comfortable with investing and taking some risk, you can increase the stock allocation to 70 or 80% to get the extra growth potential that stocks provide.
You always have to make sure to diversify the stocks in your portfolio among domestic and international stocks, small and large-cap stocks, and different sectors and industries. Bonds should be a mix of corporate, Treasury, and high-yield bonds at different interest rates among different industries.
Other Tips For Investing in your 20s
Invest in S&P 500 index fund
As mentioned before, when investing in your 20s, your investments should be concentrated on growth-oriented assets so that you can take advantage of the compounding of higher return rates on growth investments. However, you will also want to have a diversified portfolio. Building your own portfolio requires knowledge and patience. Therefore, investing in an index fund such as an S&P 500 index fund can be a great option. It spreads the risk between 500 of the U.S. largest companies, and it has had an annualized average return rate of about 10% since its inception in 1926.
Incrementally increase your savings/investment rate if possible
The earlier you start investing, the better it is, even if it means only investing an amount of $100 or less per month. You can always use an online investment calculator that can help you plan your monthly savings goal. With this investment calculator, you can figure out how much your investments will grow when increasing your monthly contribution. It will also show you how much higher your earnings will be when you start investing sooner rather than later. Compounding interest, the interest you earn on interest, adds up.
During the course of your life, your financial situation might change because of changes in your income, responsibilities, living expenses, and many other factors. In some cases, investment decisions and savings rates should be adjusted to account for these changes. Maybe your new job has a significant pay increase, or your living expenses have decreased due to your kids moving out. These are good reasons to increase your savings and/or investment rates.
Consider buying a house
Owning a home will allow you to build substantial equity over time by the home’s appreciation and paying down your mortgage. Another advantage of owning a home is leverage. With a down payment of maybe only 10,000 on a $200,000 house, you will get the benefit of appreciation on a $200,000 property. The problem with buying a house in your 20s is that you might have to move because of your career.
Rebalance your portfolio periodically, and when necessary
When it comes to investing and managing your portfolio, it is necessary to diversify as soon as possible. After all, it is best not to put all your eggs in one basket. However, since the market can change at any moment, it is best to check your portfolio regularly and rebalance it when necessary. Additionally, your financial goals may change over time, and this may require you to rebalance your portfolio accordingly to meet your new target.
Improve your investing knowledge
As previously mentioned, financial markets continuously change and evolve, and you will need to make sure that you keep up with these changes and developments. The best way to do this is to continue to improve and build upon your investing knowledge. Always do in-depth research on potential stocks and brokerage accounts. Educate yourself and ask lots of questions before making any big decisions.
Attend educational webinars, follow the blogs or social media accounts of industry experts, or bookmark and regularly check industry news sites and online forums to stay current on the latest economic forecasts, financial markets, and investment news.
Your 20s are the best time to build a strong financial foundation. Whether that involves paying off your high-interest debt, starting your emergency fund, or contributing to a retirement account, making the right financial decisions now can prevent you from having to solve financial problems in the future.
The decision to start investing is more important than how much you invest. The most important decision you can make as a young investor is to start saving and investing as soon as possible to take advantage of compounding interest and returns. Setting up automatic payroll deductions or automatic checking account withdrawals for a 401(k) is the easiest way to start investing.
Begin your journey to financial freedom by dividing your financial goals into short-term, mid-term, and long-term goals and select accounts and assets according to those goals. The right investments are going to depend on your objectives, risk tolerance, and time horizon. However, remember that you can be aggressive with your investments as a 20 something as time is on your side. The general belief is that the younger you are, the more risk you should take with your long-term investments.
Most likely, some of your plans will change over time. However, building a long-term investment portfolio in your 20s is one of the surest ways of creating financial security. Remember, the earlier you start investing, the easier it is to build wealth. Be aware that it will not be a walk in the park and take a lot of discipline and sacrifices to reach your goals.
Lastly, remember to stay on course and be patient. Market volatility and downturns are nerve-wracking but remember you are in it for the long haul. Monitor your portfolio regularly, but don’t obsess about it. It takes time to see the type of growth you are hoping for in your account.