Investors in their 20s have a golden opportunity to start out right, if they learn and follow 10 easy lessons. In this article, Paul Merriman teaches those lessons and gives a self-grading test on each one. Can you score 100?
I have to admit I don’t know your parents. But I know thousands of adult investors. And I’m very confident that in 10 simple lessons I can teach you to be a better investor than the great majority of people your parents’ age.
If you learn these 10 lessons and start applying them when you’re young, you’ll eventually wind up with hundreds of thousands – maybe even millions – of extra dollars to spend. I’ll show you how.
These lessons are not hard. They’re easy. My daughters, ages 14 and 11 respectively, have no trouble with them. I don’t think you will, either.
At the end of each lesson you’ll get to answer a simple question and score yourself. If you get every answer right, you’ll have a score of 100.
LESSON 1: Save vs. spend.
You can’t be a successful investor unless you’re an investor. And you can’t be an investor unless you have some money to invest. To do that, you have to save some money instead of spending every dollar. Is that so complicated? Yet you would be amazed at how many people just can’t seem to set money aside for the future.
Every year I speak to high school students. I call my talk “How to get rich.” I ask the students to think of all the people in the world who want them to save money. It’s usually a pretty short list. Mom, dad, grandparents, maybe somebody at a bank. But that’s about it.
Then I ask: “How many people want you to spend money?” They quickly realize that it’s practically everybody else on the planet. That reflects the commercial society we live in. Your friends want you to spend. Nike wants you to spend. Starbucks. Apple. Your cellphone company. Every other cellphone company. The Gap. Old Navy. You know the list better than I do, and you know it simply doesn’t stop.
So right away, to be an investor you have to do something that almost nobody in the world wants you to do: save some of your money instead of spending it. How do you do this? Nike said it best: “Just do it.” This one is totally under your control. Nobody can stop you from saving. And nobody can make you do it.
Here’s a guarantee: If you save some of your money and put it away for the future, you will never be sorry. Here’s another guarantee: If you don’t save some of your money and put it away for the future, someday you will wish that you had. I promise.
That’s the first lesson. Let’s see if you can pass the test.
Question: You have some money that you don’t have to spend right now, but you could spend it and impress your friends. You want to do what’s smart. Do you save this money and disappoint your friends, or do you spend it and make them happy?
1. I already know I’m smart. I want to have what I want when I want it, and I want to make my friends like me. I’m going to spend this money.
2. I’ll save most of this money for the future. I believe I can make myself and my friends happy by thinking carefully about how I spend whatever I’m going to spend.
Scoring: Zero points for #1. I’m afraid you have some serious work ahead of you if you want to be truly smart. Give yourself 10 points for #2. Eventually you’ll impress your friends a lot more by having plenty of money in savings.
LESSON 2: Save now vs. save later.
If you passed that last test and have 10 points so far, you’re going to save. You don’t have to do it today. But someday you have to. Otherwise you’ll lose all those 10 points. Worse, your friends will stop thinking about how smart you are.
Saving today is worth a lot more than saving later, and I can prove it. I’m going to assume you are thinking about saving for retirement at age 65, and that you’ll invest well enough to get a return over the years of 10 percent annually.
If you save $100 when you’re 25, at a growth rate of 10 percent your money will be worth $4,526 when you’re 66. That’s $45.26 for every dollar you save. If you wait until you’re 30, you’ll have $28.10 for every dollar you save. If you wait to age 40, your $1 will grow to only $10.83. Wait until you’re 50? Forget it: $4.18.
Let’s say you get a job and you can invest $4,000 a year. If you start at age 25 and put money in for only 10 years, stopping when you’re 35, at a 10 percent rate of return you’ll have $690,709 when you’re 60. Your out-of-pocket cost: $40,000.
But if you wait until you’re 35 to start putting away that $4,000 a year, you’ll have to keep adding $4,000 every year until you’re 60. Although you will have put in a total of $100,000 instead of $40,000, your account will be worth only $393,388.
Question: You could start putting money away for retirement this year, but you need new clothes and a car, and your friends invited you to go on a cruise to Jamaica in a couple months. You want to be smart. What do you do?
1. I’m always going to have things I want to spend money on, and it will never be different. Cruises and cars will always be there for me. But I’ll never be able to get back the time I have now to make my money grow. I’m going to start saving this year.
2. I’ve finally got a job, and I work hard. I deserve to have some fun and get a cool car. I don’t see why I should have to deny myself. Next year I’ll get a raise, and then I can start saving for the future.
Scoring: Give yourself 10 points for #1. You’ve got this lesson socked. Zero points for #2. You’ll have your fun in the sun on that cruise, but in the long run it will cost you much more than you realize.
LESSON 3: Save more vs. save less.
If you’ve got 20 points so far, I’m proud of you. Now that you’re ready to save, the question is how much. I believe that most of whatever money you earn should be yours to use. Some of it of course will always go to the government in taxes.
I recommend you get in the habit of saving 10 percent of what you earn. Live on 90 percent, and you won’t suffer very much. If you need more spending money, get a second job. (You’ll have more to spend and less time to spend it.)
You could save 5 percent instead of 10 percent. But if you do the math, you’ll see that 5 percent is a really rotten deal. If you are as smart as you want your friends to think you are, you won’t take a deal like that.
Here’s the math, Part 1: If you take home $1,000 and save $50, you have given up only 5 percent of your spending power. Nice. If you take home $1,000 and save $100, you have given up 10 percent of your spending power. Not so nice.
Here’s the math, Part II: If you invest $50 for 40 years at 10 percent, you eventually have $2,263. But if you invest $100 for 40 years, you eventually have $4,526.
Why is 5 percent is a rotten deal? Because you kept an extra 5 percent of today’s spending power (you can spend $950 instead of $900 if you saved 10 percent) but you lost 50 percent of your spending power in the future. That’s dumb.
If you increase your savings from 5 percent to 10 percent, you give up that extra 5 percent now but double your money later. That’s smart.
Question: You’re setting up your savings to come out of your paycheck, and 10 percent seems like a lot to give up right now. On the form they gave you, do you check the box that says “5%” or the box that says “10%?”
1. I’d rather have the money now than later. I’ll check the 5% box and let the future take care of itself.
2. I can get along OK on 90 percent of what I make, and I want to look forward to a better life later.
Scoring: Five points for #1. You’re not being smart, but at least you’re saving 5 percent. Give yourself 10 points for #2. You are well on your way to being a smart investor.
LESSON 4: Stocks vs. bonds.
Now that you’re actually saving money, you have to invest it somewhere. Your most basic choice is stocks vs. bonds. When you invest in stocks, you own part of various companies. You take the risk that they could fail, and you share the rewards when they make money.
If you invest in bonds, you loan money to a company that promises to pay it back, with interest along the way. The company could be wildly successful, but you don’t get any more than what the bond promised. The good side of a bond is that there’s a promise.
Buy a stock and you’re an owner. Buy a bond and you’re a loaner. Which pays more, stocks or bonds? In the 75 years from 1931 through 2005, large U.S. stocks earned annualized returns of 10.5 percent. That meant that an investment of just $1 grew to $1,787. In the same 75 years, long-term U.S. government bonds earned returns of 5.5 percent. That meant an investment of $1 grew to $55.45.
If you’ve got $100 to invest right now for your retirement in 40 years, this choice could be the difference between someday having $5,426 (stocks) or $851.33 (bonds).
Question: As you set up your saving plan at work, you can check the box to invest in stocks or the box to invest in bonds. Which do you pick?
1. This is too easy. I understand numbers. If I can have the first $100 that comes out of my pay grow to be worth either $5,426 or $851.33, I’ll take the former. Put me down for stocks.
2. Stocks are risky, and I like having a big company promise to pay my money back, plus interest. I’ll take bonds, thank you.
Scoring: Give yourself 10 points for #1. Zero points for #2. Investing in bonds isn’t dumb, and I would probably recommend that your parents have some of their money in bond funds. But if you’re young with many decades ahead of you, you need the growth you’ll get from stocks.
LESSON 5: One stock vs. many stocks.
It’s true that stocks are risky, and they can surprise you. In the 1990s, everyone knew Microsoft was a bullet-proof company. Until 1999, you would have had to work hard not to at least double your money every few years by owning that stock. But now in 2006, Microsoft stock is worth less than half as much as it was in 2000. I don’t know a soul who would have believed that in 1999.
Here’s a simple question to think about: Would you rather invest like a millionaire or invest like a poor person? Sounds pretty easy, right? But an awful lot of people in your parents’ generation still invest like poor people.
A poor person picks a few stocks and invests in them, starts believing in them and sticks with them through thick and thin. A millionaire invests in hundreds of stocks, maybe thousands of stocks – and doesn’t care much about any one of them. If one stock goes belly-up, there are so many others that it doesn’t really matter.
The good news is that even with a small amount of money, you can invest in hundreds of stocks through a mutual fund.
The past 10 years has been a good period for stocks in general, with the U.S. stock market up over 8 percent a year in the 10 years ended June 30, 2006 (measured by the Standard & Poor's 500 Index).
But more than 30 percent of the individual stocks you could have bought in 1996 are worth less today than they were then. If you bought a stock chosen at random and held it for 10 years, there’s three chances out of 10 you would have lost money.
By contrast, if you had invested in 1996 in a mutual fund that invested in U.S. stocks, there’s less than a 1 percent chance that fund would have lost money. This is why millionaires invest in lots of stocks. You can do that too, using mutual funds.
Question: You can invest in mutual funds or pick individual stocks, hoping you can outsmart everybody else. Which do you do?
1. I’ve already got 40 points in this quiz, proving that I’m pretty smart. My dad knows a lot about stocks, and he’ll help me pick the winners. I’ll do that instead of those boring old mutual funds.
2. I think I’m smart, and I’ll put my brains to work doing what I do for a living. When it comes to investing, I’ll do what the millionaires do. Give me mutual funds.
Scoring: Zero points for #1. I’m afraid some of your brains have just leaked to where they shouldn’t be. Give yourself 10 points for #2.
LESSON 6: Pay taxes vs. don’t pay taxes (legally, of course).
This is a lesson that’s worth a ton of money to you, so be sure you get it right.
As soon as you start earning income that you have to report on a tax form to the IRS, you are eligible for one of the best tax breaks you will ever get from the federal government. It’s called a Roth IRA; the letters stand for Individual Retirement Account. You could think of it as your own private pension.
When you get a job, you may also have the opportunity to save some of your pay in a Roth 401(k). The two are similar. I’ll use the Roth IRA to show why they matter.
This year, your annual Roth IRA contribution is limited to $4,000 or the total of your earned income on your tax return, whichever is less.
I told you this is a tax break, and it is. You don’t get to take a tax deduction for the money you put in. In other words, your contributions come from money that’s already been taxed. But the other side of it is that whatever you earn in the account will never be taxed.
The Roth IRA is particularly valuable if you put money in when you’re young, because taxes could otherwise eat up a good chunk of your earnings.
Let’s think about just one year’s contribution. Say you are 20 years old and you save $4,000 for your retirement in an investment that earns 10 percent for 40 years. Inside a Roth IRA, that one-time $4,000 investment would grow to be worth $181,037. (That’s a pretty amazing piece of math by itself, and I had to do the calculation a second time to make sure it was right!)
If you continued to earn 10 percent, at age 60 you could start taking out $19,204 every year and have those withdrawals last for 30 years. That’s a total of $576,128 over your lifetime from one investment of $4,000.
What if you did the same thing but in a taxable account instead of a Roth IRA? I believe it’s safe to assume your after-tax investment return would be reduced to 8.5 percent a year because of annual taxes on dividends and capital gains distributions. At age 60, you would have not $181,037 but only $104,532. Failing to use the Roth IRA cost you 42 percent of your return over those 40 years.
But it gets worse. If you continued to earn 8.5 percent every year, you could take out $9,727 a year starting at age 60. Future tax rates are impossible to predict, but let’s assume that one-quarter of what you withdraw would be subject to income tax at a 20 percent rate. That means that after taxes, you would have $9,241 to spend every year for 30 years. That’s a total of $277,220 over your lifetime.
Invest $4,000 when you’re 20 years old and you could turn it into $576,128 using a Roth IRA or into $277,220 without the Roth IRA. It’s your choice.
Question: You have some money you can put aside for your long-term future. Do you invest it in a Roth account or in a non-sheltered account?
1. I can tell the difference between $277,220 and $576,128. Unless this is a trick question and there’s something important that I’m missing, I’m going to put that money into a Roth IRA. I’m smart.
2. Those numbers sound impressive but I don’t want to tie my money up for 40 years just to save a little bit in taxes.
Scoring: Give yourself 10 points for #1. you understand a deal when you see it. Zero points for #2. Frankly, I’m worried about you. And by the way, you aren’t required to leave that $4,000 in the Roth IRA until you’re 59½. After you’ve had the account open for five years, you can take out your original contributions any time without penalty or tax. Because I didn’t tell you this until now, you get a second chance to answer this question.
LESSON 7: Load funds vs. no-load funds.
This is one of the easiest lessons you’ll ever learn, but hundreds of thousands of people in your parents’ generation don’t do it right.
When you invest in a load fund, you pay a sales commission. When you invest in a no-load fund, you pay no sales commission. Fund loads are complicated, partly because the fund industry wants them to be hard to understand. But to make my point, I will use the most common form, the front-end load.
Back to the $4,000 that you’re investing in that Roth IRA at the age of 20. If you buy a no-load fund, the entire $4,000 goes into the fund’s portfolio for your benefit. You’ll eventually take out about $576,000 over your lifetime, as we saw in Lesson 6.
If instead you put $4,000 into a fund that charges a 5.75 percent commission, the fund skims $230 off the top and invests only $3,770 in the fund’s portfolio. At our 10 percent assumption over 40 years, that would grow to be $170,627 by the time you’re 60. Under the same assumptions as in Lesson 6, this would let you take out $18,100 a year for 30 years before the money is gone.
The difference is $1,104 per year for 30 years, a total of $33,120. That’s the amount of money you would give up over your lifetime because you paid the $230 sales commission when you were 20. I repeat, the real cost of that one-time sales commission was $33,120, or more than eight times your entire investment of $4,000.
Question: A friendly, likeable advisor wants you to buy a load fund, and he says the load won’t make any difference over the long run. Do you do what he wants, or do you buy a no-load fund that invests in similar stocks?
1. My mom says I should trust this advisor, who has helped the family with money for a long time. She says he wouldn’t recommend anything that’s bad for me. I’ll do what he says.
2. I’m going to buy the no-load fund. If I want to be nice to this advisor and not hurt his feelings, I can treat him to a very fancy dinner for a lot less than $33,000!
Scoring: No points for #1, though you will have lots and lots of company. Unfortunately, you will be making part of your money work hard for that advisor when it could just as easily be working for you. If they would let me, I’d give you negative points for this. But the rules are the rules. Give yourself 10 points for #2. You are obviously smart.
LESSON 8: Low expenses vs. high expenses.
All mutual funds charge expenses, and investors who own a fund share common costs. But some funds charge a lot more than others. The expensive ones argue that you get more, but this is a case where the statistics indicate that the opposite is true. Every dollar you pay in expenses is a dollar of your investment return that goes to somebody else, not you.
You can get excellent stock funds that charge annual expenses of 0.4 percent or less. But many stock funds charge a lot more. I’ll use an expense ratio of 1.4 percent to represent expensive funds (some charge more than 2 percent!).
Once again let’s go back to the $4,000 investment in an IRA when you’re 20 years old. Imagine that you have a choice of two funds with essentially identical portfolios. One charges 0.4 percent, the other 1.4 percent. Which is going to have the higher return? Obviously the one that charges only 0.4 percent.
If we assume you would get a 10 percent return from the fund that charges only 0.4 percent, then we can assume your return would be 9 percent from the more expensive fund.
Here’s what that means: Choose the inexpensive fund and you’d have $181,037 at age 60; choose the expensive fund and you’d have only $125,638. Choose the inexpensive fund and over your lifetime you’d get back a total of $576,128; choose the expensive one and you’d get back a total of $366,873.
An extra 1 percent of expense would cost you $209,255 over your lifetime – all on a puny $4,000 investment.
Question: You have to choose between two similar funds. One charges 1.4 percent expenses. The other one charges only 0.4 percent in expenses. Which do you buy?
1. I like the literature from the more expensive fund. I’ll take it. This is only a lousy 1 percent that I would save.
2. You’ve got to be kidding me. There’s no way I’m going to pay $209,000 for fancy literature. I’ll take the cheap fund.
Scoring: You get zero points for #1. There probably isn’t much hope for you. Stop now. Don’t go on. The two remaining lessons will be wasted on you. Give yourself 10 points for #2. You are smart.
LESSON 9: High tax efficiency vs. low tax efficiency.
This is a variation of Lesson 8. Recurring expenses act like an anchor being dragged behind a boat. The same is true of taxes. Some funds are tax-efficient because they don’t buy and sell their stocks very much, so they don’t create a lot of capital gains on which their shareholders have to pay taxes. Some funds are specifically managed to keep taxes low.
But other funds don’t seem to care much that their actions can mean the shareholders get stuck with paying taxes every year.
Tax efficiency doesn’t matter in a tax-sheltered account such as an IRA or a 401(k). But the chances are very good that you’ll also have some non-sheltered investments. If you put that money in funds that are tax-inefficient, you can lose 15 percent of your return each year to the tax man. This means you don’t have that 15 percent working for you any more.
Starting with the assumption of a 10 percent annual return, that means a tax-inefficient fund would grow at a rate of only 8.5 percent. We saw in Lesson 6 that over 40 years on a $4,000 investment, that’s the difference between having $181,037 when you’re 60 or having only $104,532.
Subsequent tax treatment of these two theoretical accounts is hard to estimate, but I think it’s very safe to say you would have a lot less to spend in retirement from $104,532 than from $181,037.
Question: For an account that’s subject to taxes, you can buy an index fund that’s very tax efficient or another fund that’s tax-inefficient. Which do you choose?
1. I’ll pay my taxes when I have to, but why rush? Give me the tax-efficient fund.
2. I want to pick the funds I like, and I don’t want to be bothered with figuring out tax stuff. I’m not going to worry about this.
Scoring: Give yourself 10 points for #1. You’re doing just fine. Zero points for #2. You can ignore this topic, but you won’t get any extra thanks from the government for paying unnecessary taxes.
LESSON 10: Automatic vs. when you feel like it.
Remember Lesson 1, the issue of saving money or not saving money? Many people never feel like investing. They’d rather spend the money than save it. After it’s been invested awhile, they’d rather do something else instead of rebalancing their portfolios (an annual task we haven’t discussed). The result is that critical things don’t get done when they should. We saw in Lesson 2 that doing it now is much more valuable than doing it later.
The answer to all these things is easy: Put your investing on automatic pilot. You can put your savings on automatic by having money taken out of your paycheck or your bank account regularly so you don’t have to think about it.
Just about every task associated with investing can be done automatically. That way you know it will happen whether you feel like it or not. That is what I do with my investments. I recommend you do the same.
Question: You get a chance to sign up for automatic investments from your paycheck. Do you say yes or no?
1. This is a no-brainer. Yes.
2. I’ll get around to it later, but right now I have some bills to pay off. I’ll pass for now.
Scoring: Give yourself 10 points for #1. Zero points for #2. Where were you when the brains were passed out?
Now you can add up your points, out of a possible 100. If your score was less than 30, you need more than I can give you. If it’s 30 to 45, there’s some hope; you should read these lessons again. If it’s 50-80, you could benefit from re-reading the ones you missed. If your score is 85 or above, you’ll most likely be a better investor than your parents. If you got 100, my hat’s off to you!
These 10 lessons may seem very obvious, but millions of people in your parents’ generation don’t put them into practice.
I can summarize these 10 lessons in just a few sentences.
Don’t spend everything you earn. Make your savings automatic, and start saving money as early as you can. Invest 10 percent of your pay in low-cost, tax-efficient no-load mutual funds that invest in stocks instead of bonds. To whatever extent you can, make your investments in a Roth IRA or a Roth 401(k).
If you get in the habit of doing those things, I promise you will be a better investor than your parents. For one thing, they never had the opportunity to invest in a Roth account when they were young.
Put all these lessons into practice and you won’t be sorry. That’s a promise.