Dear Clients and Friends of Cornerstone:
This month’s article gives some great advice to our younger generation of investors – those in their 20s and 30s – on where and how to begin thinking and saving for their future. If that is you, or if you have children at this stage in their life, please share this article with them.
If you would like to refer back to any previous newsletters we have published, you can find them on our website. Please be sure to visit www.ccadvisors.com.
– Cornerstone Capital Advisors
An Investing Road Map for Early Career Accumulators
Tips on getting the most bang for your investment dollars when you’re just starting out.
Because they’re just starting out, early career accumulators–loosely defined as people in their 20s and 30s–don’t typically have much in the way of financial capital (unless they’re technology savants or supermodels, that is). Not only are their earnings often low relative to where they’ll be in the future, but new college grads may also be digesting college debt.
But early career accumulators have other assets that their older counterparts can look upon with envy. With a whole lifetime of earnings stretching before them, early career people are long on what investment researchers call human capital: Their ability to earn a living is their greatest asset by a mile. Investors in their 20s and 30s have a valuable asset when it comes to investing, too: With a very long time horizon until they’ll need to begin withdrawing their money (for retirement, at least), early career investors can better harness the power of compound interest. They can also tolerate higher volatility investments that, over long periods of time, are apt to generate higher returns than safer investments.
If you’re just embarking on your investment journey, it’s hard to go too far wrong with the mantra of investing as much as you can on a regular basis and sticking with very basic, well-diversified investments. But it also pays to think of your “investments” in a broad sense, steering your hard-earned dollars to those opportunities that promise the highest return on your investment over your time horizon. For most people, that will require a bit of multitasking: Rather than wait until all of your student loans are paid off to begin investing in the market or saving for a down payment for a home, for example, you may want to earmark a portion of each paycheck for all three “investments.”
Here are some tips for investing well and yes, multitasking, in your 20s and 30s.
Put Debt in Its Place
Make the Investment in Human Capital
Build a Safety Net
An emergency fund is also essential, as having a cash cushion on hand can keep you from having to resort to unattractive forms of financing like credit cards or raiding your 401(k) if you lose your job or encounter a surprise expense. While the rule of thumb of stashing three to six months worth of living expenses in cash might seem daunting, remember it’s three to six months worth of essential living expenses, not income. This article includes tips for emergency funds and what type of investments to put inside them.
Kick-Start Your Retirement Accounts
Yet the youngest investors have the longest time to benefit from compounding, and that benefit accrues even if they’re only able to save fairly small sums and the market gods serve up “meh” returns over their time horizons. The 22-year-old who starts saving $200 a month and earns a 5% return per year will have more than $362,000 at age 65. Meanwhile, an investor who waits until 35 to start investing yet socks away $300 a month and earns a 6% return will have a little more than $300,000 at age 65. Those first 10 years of missed compounding swamp both higher returns and higher contributions later on, underscoring the virtue of getting started on retirement saving as soon as you can, even if it means starting small.
Focus on Tax-Sheltered Vehicles
A company retirement plan, if one is available, is invariably the simplest way to get started on retirement savings. Not only do many company retirement plans offer matching dollars on employees’ own investments, but having contributions extracted directly from a paycheck helps reduce the pain of investing. (If you never put your mitts on the money, you won’t miss it.) Making automatic contributions also helps enforce disciplined savings, even when the market is falling or your cash flows are at a low ebb. Of course, you could pull back on your 401(k) contributions once you set your initial contribution rate, but in reality, few participants do that.
For early accumulators whose company-provided are poor, it’s always worthwhile to contribute enough to earn the match; after that, turn to an IRA for your additional investable assets. If you still have money left over to invest after meeting the match on your employer-provided plan and making an IRA contribution, you can then go back to your company retirement plan and make the maximum allowable contribution. Only after you’ve taken full advantage of those tax-sheltered vehicles should you consider an investment in a nonretirement account (i.e., a taxable brokerage account).
Choose Roth if Your Taxable Income Is Low or if You’re Multitasking
Pretax (traditional) contributions offer immediate gratification, in that all of your investment dollars can start working for you on day one, without paying taxes. But Roth contributions can actually make more sense for young accumulators, whose tax rates at the time of contribution may well be lower than when they begin withdrawing money in retirement.
Roth IRA accounts offer an additional attractive feature that traditional accounts do not: Contributions can be withdrawn at any time and for any reason without taxes or penalties. That makes a Roth IRA a perfect “multitasking” account for investors who need to build up both an emergency fund and retirement assets. Worst-case scenario, the IRA is a rainy-day fund; best case, the money in a Roth compounds tax-free for retirement.
Invest in Line with Your Risk Capacity
When it comes to retirement savings, early career accumulators have high risk capacities because they won’t likely need their money for many years to come. That’s why retirement portfolios usually feature ample weightings in stock investments: Even though they feature sharper ups and downs than safer securities like bonds and cash, stocks have historically rewarded their long-term investors with better returns than other asset classes. That helps explain why Morningstar’s Lifetime Allocation Indexes (which provide asset allocations for investors at various life stages and with different risk tolerances) and most target-date mutual funds hold about 90% in stocks and the remainder in bonds and cash.
On the other hand, if you’re investing for shorter-term goals–such as a home down payment, you probably don’t want to have much, if anything, in stocks. Yes, the returns from bonds and cash are lower, but they’re also much less likely to encounter big swings to the downside. This article includes some guidance and model portfolios on investing for short- and intermediate-term goals.
Employ Simple, Well-Diversified Building Blocks
Instead, focus on low-cost, broadly diversified investments. For investors just starting out, target-date mutual funds can take the mystery out of the investment process: These funds employ aggressive, stock-heavy postures when investors are in their 20s, 30s, and 40s, then gradually become more conservative as retirement draws close. Moreover, the best target-date funds invest heavily in low-cost, well-diversified investments themselves; Vanguard’s Target Retirement Fund Series and BlackRock’s Lifepath Index Target Date Fund Series are both highly rated target-date lineups.
If you don’t want to delegate control of your portfolio’s stock/bond/cash mix and investment selection, a simple way to put together a well-diversified portfolio is to employ index mutual funds or exchange-traded mutual funds. Such funds track a segment of the market, such as the S&P 500, rather than trying to beat it. That may sound uninspired–and uninspiring. But broad-market index funds often have the virtue of very low costs, which can give them a leg up on actively managed funds over time. (The most recent issue of Morningstar’s Active/Passive Barometer tells the tale.) If you do opt for actively managed funds for all or a part of your portfolio, low expenses should still be a key priority, as discussed here.