Millennials haven’t had an easy journey. Born between 1981 and 1996, this generation has faced significant challenges, including the Sept. 11 attacks, subsequent wars, the worst recession since the Great Depression, a student loan crisis, and a global pandemic. It’s no wonder that saving and investing for retirement might not have been a top priority.
However, with most millennials having finished school and worked for several years, it’s time to consider investing as a way to achieve long-term financial goals.
Let’s explore some investing basics and why it’s crucial to get started.
Why it’s important for millennials to invest
Experiencing the 2008 financial crisis may make investing seem risky, but avoiding investments carries risks too. Not saving and investing in your mid-20s to mid-30s can be detrimental. Investing early gives your money time to grow. Despite market fluctuations, it’s rare for the stock market to stay down for extended periods.
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Stock investments yield higher returns than cash and bonds over time. Money in savings accounts remains stagnant and loses value due to inflation, while stock market investments can grow through compounding. Large capitalization stocks returned about 10 percent annually from 1926-2020. In comparison, long-term government bonds returned about 5.5 percent annually, and T-bills around 3.3 percent annually.
Building wealth over long periods is best achieved through a diversified portfolio of common stocks. Investing over time creates a snowball effect. Starting to compound early allows the interest on your investments to generate further interest, leading to substantial growth.
For instance, if you invested $6,000 annually at age 25 and earned $100 in interest that year, by age 26, you’d earn interest on $6,100, then on $6,300, and so forth. Over the years, this would result in significantly higher returns compared to simply saving that money.
Educate yourself on the basics
Risk tolerance: Understanding your risk tolerance is essential before making any investments. Risk tolerance refers to your ability and willingness to endure investment losses, whether temporary or permanent. While the stock market generally rises over the long term, it can experience significant declines in shorter periods. Assess whether you can withstand these downturns or if safer investments are more suitable for you.
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Asset allocation: As you build your investment portfolio, decide how much to allocate toward stocks versus other assets like bonds or real estate. Assets can also be categorized by geography, investing style, or company type. This mix, known as asset allocation, will likely shift from riskier assets early in your investing life to safer assets as you approach retirement.
Active vs. passive: Determine if you want to be an active or passive investor. Active investors try to outperform popular market indexes like the S&P 500 by picking winning companies. Passive investing, or index investing, aims to match the performance of broad indexes and is typically available at a lower cost. This cost advantage has generally led passive investors to outperform active investors over long periods.
Diversification: Diversification is akin to the saying, “Don’t put all your eggs in one basket.” By spreading your investments across various assets, you acknowledge that some will perform well while others may not. Broadly diversified portfolios have historically performed well over time.
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Time horizon: Knowing your time horizon is crucial in any financial plan. Identifying key goals, such as saving for retirement or a child’s education, will significantly influence your investment strategy. Long-term goals, at least five years away, usually involve long-term assets like stocks. Short-term goals, such as saving for a house down payment, are better served by safer investments like high-yield savings accounts.
Learn the types of accounts
IRA: An Individual Retirement Account (IRA) allows you to save for retirement with significant tax advantages. Contributions to an IRA grow tax-free, enabling higher returns through compounding without ongoing tax payments. You contribute pretax funds, potentially reducing your current tax bill. Withdrawals can start at age 59 1/2, at which point you will pay taxes on the withdrawn amount.
Roth IRA: Similar to a traditional IRA, a Roth IRA has key differences. Contributions to a Roth IRA are made with after-tax money, so there’s no immediate tax benefit. However, withdrawals at age 59 1/2 are tax-free. This tax advantage makes Roth IRAs an excellent retirement savings vehicle. Note that early withdrawals from both Roth and traditional IRAs typically incur a 10 percent penalty.
401(k): One of the most popular workplace retirement plans, a 401(k) allows employees and employers to allocate a portion of earnings for retirement investment. Many employers match employee contributions up to a certain amount, which is essentially free money from your employer. Contributions grow tax-free, but withdrawals, usually starting at age 62 or 63, are taxed.
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Brokerage: A brokerage account lets you invest in securities like stocks, bonds, and ETFs. Unlike retirement accounts, brokerage accounts are taxable, meaning you pay capital gains tax on realized gains. If you’ve maximized your retirement savings in accounts like 401(k)s and IRAs, a brokerage account is a good additional wealth-building tool. Many online brokers offer commission-free trading, and you can access your money without penalties whenever needed.
These are some of the most popular types of accounts, but there are others worth knowing about as well.
Best investments for millennials
Stocks: For long-term goals like retirement, stocks are ideal for millennials. Owning stocks means holding partial ownership in a business, and over time, their performance will reflect that of the underlying business. You can invest in stocks individually or through ETFs and mutual funds.
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Index funds: Index funds are mutual funds or ETFs designed to mirror the performance of an index such as the S&P 500 or the Dow Jones Industrial Average. They can include stocks, bonds, or real estate. Being passively managed, index funds have very low costs, allowing investors to keep more of the returns. They are an excellent way to build a broad, diversified portfolio with minimal fees.
ETFs: Exchange-traded funds (ETFs) hold a basket of securities and trade like stocks throughout the day. You can invest in various types of ETFs, including stock ETFs, bond ETFs, and commodity ETFs. Many ETFs passively track indexes like the S&P 500 or the Russell 2000, making them a great option for building a diversified portfolio even with limited funds. Unlike mutual funds, ETFs usually don’t have a minimum investment requirement.
Mutual funds: Mutual funds pool money from multiple investors to invest in a range of securities like stocks or bonds. Your investment mirrors the fund’s asset distribution, so if the fund holds five percent in Microsoft, your investment will also have five percent in Microsoft. Unlike ETFs, mutual funds only trade once a day at the closing NAV price. They can be purchased through a broker or directly from the fund company, usually with a minimum investment of a few thousand dollars. The returns of mutual funds depend on the performance of the underlying assets they hold.
These investment options offer various ways for millennials to build wealth over time, depending on their individual financial goals and risk tolerance.
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