If you aim at nothing, you'll hit it every time. ~Author Unknown
You must have long-range goals to keep you from being frustrated by short-range failures. ~Charles C. Noble
Welcome to Part 1 of the April blog series: Investing For Young Adults. If you missed the introduction, you can check it out here. After you read Part 1, please leave any comments or suggestions. In particular, please let me know if this is useful information and anything I can do to make it better. Thanks!
Compound Interest
The underlying focus of this first post is the absolute importance of setting financial goals and immediately getting started towards those goals, but I'd like to start off with a discussion of one of the fundamental principles of investing: compound interest. This may sound like an odd place for such a discussion, but my purpose here is to get you motivated and excited about investing, and nothing is quite as exciting as compound interest, despite the decidedly unexciting name. Albert Einstein reportedly called it the greatest mathematical discovery in history, and after you become familiar with it, you probably will too.
But first, let's talk about you. Maybe you know a little about investing, and you feel like you should be doing something, but you're not sure what, and you don't know where to start. It's true that personal finance and all the options for investing can be overwhelming for someone just graduating from college. In addition, retirement seems so far away that it doesn't seem that urgent and you assume you can always worry about it later. Big mistake. While you may be able to make up for lost time in the future, it will never be as easy as it is right now. You may not have much money to invest, but the younger you start, the less money you need to put aside each month and still meet your goals. Consider the following example:
Jack and Jill both graduate college at age 22 and get decent jobs. Jill decides that she can spare $200 / month to save for retirement. Every year for 10 years, she adds $2400 to her retirement account, which earns 10% annually. After 10 years, she decides she's tired of investing that $200/month and stops, leaving the account as-is.
Jack decides at the age of 22 that $200 / month can buy a lot of fun. He uses the money to buy sports equipment and beer. However, by the time Jack is 32, he's married and starting to think seriously about the future. He decides he better start setting some money aside and begins to put $200 / month into a retirement account, also earning 10% annually.
For the next 30 years, Jack faithfully puts $200 / month into his retirement account and Jill completely ignores hers. After 40 years, at age 62, their balances are as follows:
Jack's total investment of $72,000 has grown to $392,386.
Jill's investment of $24,000 has grown to $667,436.
Jack would have needed to contribute $340 / month for those 30 years to match Jill's earnings from just $200 / month for 10 years. If Jill had decided to keep contributing $200 / month for the entire 40 years, she would have ended up with more than $1 million.
This apparent mathematical oddity is explained through the miracle of compound interest, which sounds more complicated than it really is. Compound interest essentially means that over time, you earn interest on your original investment (called principal) and you earn money on any interest from earlier periods. For example, if you deposit $1000 into an account earning 10%, after a year, you'll have your original, plus $100 in earnings, for a total of $1100. But at the end of the second year, you won't have $1200. You'll have $1210, because you earned 10% not only on the original $1000, but also on the $100 that you earned in year 1. That $10 may seem insignificant, but as the example above shows, it adds up over time.
What you really need to know about compound interest is that your investments grow much more in the later years than in the early years, so if you start earlier rather than later, you will make a LOT more from your investments.
Here's a last example. Suppose you put $1000 into an account bearing 10% interest. After 40 years, that $1000 will have grown to $45,259. Pretty amazing. However, what's really interesting is the value of the account at the end of each decade:
As you can see, almost 2/3rds of the increase from $1000 to $45,000 came in the last 10 years. If you left it invested for another 10 years, for a total of 50 years, you would have $117,391. Sixty years would get you to $304,482. All from that original $1000.
The bottom line here is that every day you wait to start investing for the future, you're wasting some of that tremendous earning power. You may not make much money in your twenties, but you have an unstoppable force behind you that gives you a distinct advantage over those who are older and make a lot more money: time. Don't waste it.
When you're in your twenties, it can be tempting to go out and "enjoy your youth," spending all of what you make. My goal here is to help you realize that the sooner you start, the less you have to put aside for the future (because of compound interest) and the more you'll be able to enjoy your youth and the years to come.
Task 1: Write a prioritized list of financial goals
When it comes to getting started with something, nothing helps like goals. So our first action is going to be to write a list of financial goals. This is not meant to be a full financial plan. Our purpose here is to come up with a list of rough financial goals that you would like to achieve. You don't need to attach numbers or times to these goals yet, though you may want to. Here are a few examples to get your creative juices flowing:
Sample Financial Goals
Once you have all of these goals written down, prioritize them by asking yourself the following question: "If I could only accomplish one of these goals, which would it be?" After you select a goal, write #1 next to it and ask the question again for the remaining goals, until they're all gone. I'll give you a hint: retirement and buying a house should almost certainly be first on the list. It can be tempting to put kids' college above those goals, but if your kids have no money to pay for school, they can always apply for scholarships and/or borrow money. There are no retirement loans or scholarships, so make saving for retirement your first priority. In fact, because preparing for retirement will take up such a large chunk of your investment dollars, we'll tend to focus on it more through the rest of the series.
Take some time with these goals. Think about your attitude towards money and what is a good fit for you. Think about what you would like your financial life to be like. I understand that you may have no idea what you want in some areas of life, but do your best to come up with some rough directions and then put them on paper. This will give you a starting point for understanding what your financial plan should look like. Now go do it.
Check back on Wednesday, April 4th for Part 2: Financial Health
Disclaimer: I am not a professional financial adviser. All information herein is provided in good faith. It is not intended to be, and should not be relied on as, a substitute for independent legal, financial, tax or other professional advice. Readers should seek appropriate legal, taxation, accounting, investment or other expertise in their local and overseas jurisdictions.