For those of you who have recently graduated from college, you might be looking at that first job and thinking how much you can get with your new salary – a nice apartment, a new car, lots of spending cash, etc….. Hopefully, you are not already up to your neck in college loans. It is time to really assess your situation.
When most of us graduate from college, it is a time when all the earnings coming in are for one and only one person – ourselves. That means you don’t have to pay a mortgage, pay for insurance for a family, buy clothing for a family, etc. In essence, it means if you play your cards right, you can really get ahead by using your salary to your advantage. After all, most of your expenditures are discretionary.
Unfortunately, most recent college graduates will NOT take advantage of this. Ten years after college, many will be highly saddled with debt and the outlook will only involve more debt. At that time, it will be harder to get out of debt, because many of the expenditures become necessities. Furthermore, you will have lost a key component of investing – TIME. Don’t let this be you!
It is vital that you begin to really understand interest rates in conjunction with time. When I graduated from college, car loans were three to five years in length. Now loans are stretching seven plus years! Honestly, after two years that new car doesn’t look very new anymore and you still have many years left to pay on it. In essence, buying a brand new car can eat up your new salary quickly and slow your journey to financial independence.
A good way to look at interest rates is the difference between what people who want to spend now will pay to someone who is willing to defer spending until later. Many will choose to spend now. Unfortunately, that will be the beginning of habits that will grow worse over time. NO ONE EVER has gotten financial ahead by spending more than they make.
Your first goal should be to develop habits that enable you to spend less than you earn. This will give you money to invest. When you invest, you are loaning funds to someone who wants the use of those funds now. You get a return (interest rate) for loaning the funds. Now think of the person who is spending more than he makes. Each month they are going further and further in debt. Additionally, interest is being added on to the debt, making the debt even larger.
Other than having mostly discretionary expenses, the twenty something also has the advantage of time. At 20, there are 45 years until retirement at age 65. This is where many will say to themselves, “I have lots of time to do that, I can put it off.” Ask many baby boomers in their late 50’s, how they are getting their financials ready for retirement. Either they don’t know (which is really terrible for their retirement) or they are saving at a gargantuan pace to have even a modest retirement. By saving early in your career and using compounding over time to your advantage, you can avoid the pain that many boomers are feeling right now!
Now, assuming you are spending less than you are making, you will have money to invest. Your best long-term investment will be stocks. I started investing in stock mutual funds early in my career. At this point, I wish I had taken a slightly different approach. This is the reason why. In the early 2000’s I stopped putting money in stock mutual funds and starting investing more in individual stocks. The returns to date have been about 9% yearly compounded rate for stock mutual funds and have been 15% yearly compounded rate for individual stocks. Why is the difference 6%? Much of it has to do with paying fees.
Mutual funds charge fees for their services. One fee they have is called a load. With a load, the investor pays 5 to 6 % right up front. So if you pay 5%, only $95 of every $100 investment will be invested for you. In essence you start 5% IN THE HOLE. Funds that charge loads claim they have a better returns over time. They have never been able to definitively prove better performance for the load paid. As a result, most funds are now no-load funds. 100 percent of your investment goes to work for YOU in a no-load fund! For the record, I have NEVER PAID A LOAD to invest in any fund.
Next mutual funds charge an annual fee for their services. Every mutual fund has these annual fees. The only thing you can do is minimize them. I always had a rule to never pay more than one percent! One percent sounds rather small, but for each fee you can reduce, you have more money growing for YOUR RETIREMENT. Over long periods of time, that amount can be really significant.
The economics of mutual funds is that once a certain amount of money is under management, the profitability to the mutual fund company running the fund is absolutely huge. The management of a 100k fund is generally the same as a 100M fund. This is where the economies of scale really benefit the mutual fund company. One percent of 100K is 1K and 1M of 100M. Now imagine a 300B fund, one percent is 3B. That is a lot of fees to cover maybe 2 portfolio managers and 10 analysts. They all get paid princely salaries and the mutual fund management company makes even more. Who is the beneficiary of YOUR investments?!
In the current environment, many investors are moving over to index funds who may charge a half a percent or less in annual fees. Why? The majority of funds described in the previous paragraph (active funds), do not beat the index in any one year. When you look at 2 years, the percentage of funds beating the averages grows even smaller. For 5 years out, I would bet that less than 5% of active manager beat the index. There have been a number of studies on this that can give you the exact numbers. But, the bottom line is that you have a very little chance of picking the manager in the 5%. Furthermore, the managers who make up that 5% change over rolling multi-year periods.
What this means is that you can get just as good a return in an index fund than active fund and cut the fees significantly. Think of it this way. For every fee you cut, you increase the probability of YOU making more money. Remember, the annual fee is taken out every year. If your return was 8% on the active fund, the fund’s return would have been 9% adding the one percent fee the active fund charged. Active managers will argue that they can add more value for the one percent fee, but there is NO CONSISTENT EVIDENCE of that in any study that has been done, only strong marketing by the fund!
So maybe you put your money in an index fund, but there is another way to reduce fees even more. This is by investing directly in stocks. Many brokerages charge $5 to buy or sell a block of stock. That represents a very small percentage of your investment. Now many may be a little uncomfortable with direct investment. For those folks, they may choose to invest in index funds, but if you are willing to go to individual stocks, the returns can be huge. You will have to invest your time and energy to continue your education in the business, stock and economics areas. You should only do this if you are willing to continually educate yourself. Warren Buffet spends most of his days READING – not trading. Mr. Buffet’s advice is to read a great deal EVERY DAY.
For individual stocks, I would suggest buying several high quality well-known companies with consistent dividends. Don’t chase those high flying stocks that everyone is talking about. Think boring. Boring can be beautiful when it comes to investments. This is a page out of Warren Buffet’s playbook. A good analogy would be the turtle and the hare fable. The turtle plods along steadily (you should be the turtle) while the hare races ahead, but decides to take naps. The turtle eventually wins by a large margin.
With each market cycle, people get into the stock market at exactly the wrong time – on the high side. They invest in sexy stocks expecting to make a killing. When the market turns on them, they disavow putting money in the market ever again. This puts them in the position of having very little chance to gather enough assets to retire. This type of activity would be considered speculation. You DO NOT want to be a speculator. You WANT TO BE an investor.
You definitely want to make sure you don’t pay too much for those high quality stocks. Even high quality stocks become too “expensive” at a certain point in the market. While you don’t know definitively whether the stock market is at its high point or low point, you should know if it is “relatively” high or “relatively” low. Unfortunately, there is no bright line to tell you this, but this is why you MUST CONTINUALLY educate yourself about investments. Sure, you want to buy at the lowest point and sell at the highest point, but people who have been investing their entire career are unable to accomplish this feat. What makes you think you can do what someone who invests every day for years and years cannot do?
Right now (April 2017) we are at a “relatively” high point in the market, so “good values” are not generally available. This means you should probably continue to build your savings while continually educating yourself about investments. Your informal/formal education would be a good “investment”.
When I invest, I begin with a general and much simplified benchmark of not paying for a stock higher than a 15 Price Earnings ratio (PE). This anchors you from paying too much. When the market becomes “relatively” low, buy an equal dollar amount of each of several high quality stocks. You don’t have to buy 100 shares or more of each stock. With brokerage commission being so low at discount brokerages, you can easily buy 5, 10, 15 or more shares at a time with low commissions. Don’t put all your eggs in one basket. No matter how favorable you feel a single investment is, DO NOT put everything in one basket. Keep adding baskets. This is referred to as diversification.
Now, hold those securities for the long term. Let me clarify long-term. This can mean 15 minutes for some people. I mean 10, 20 or more years out. Sure, some of those investments may not pan out, but the successful ones will very likely make up for those less than stellar investments and far out shadow the less stellar ones. The prices of stocks can vary substantially over the economic cycle. Don’t get nervous and sell out when they go down. One thing is for sure, the market WILL GO DOWN at some point. Keep your wits about you and DON’T act emotionally. Emotional investors always get creamed. Remember, the companies you have bought are high quality well-known companies such as Johnson and Johnson, Intel, ATT, etc. When they go down, think of it as a “sale”. While this is emotionally difficult, this is where you should be buying. Be patient for the next upturn. It will come, but it may take longer than you expect. Think of it as an extended “sale”.
Now you have the basics. It is important for you to start to form those saving habits now (spend less than you earn) and start taking advantage of the compounding effect of investment. Whatever you do, do not raid your investment account for other purchase or you will severely diminish the compounding effect of your investments. Don’t fool yourself. Your educational career has not just finished, but has just started. Embrace it. Also, it takes a long time to build your base, but once the base is built and the compounding takes hold, the growth will take on an exponential path. This will likely be 15 or 20 years out.
Oh, one more thing. A good benchmark to focus upon is this. If you want to have 40K income in retirement and interest rates are 4%, you will need 1,000,000. No one knows what interest rates will be in 40 to 45 years, but 4% would be a good estimate to start with. So, if you want 80K in retirement, you will need 2,000,000. This can seem unreachable at this point, but by using consistent saving, fee reduction, time and compounding to your advantage you can reach these goals. The point is that the time to start is NOW. Time is YOUR FRIEND early in your career and time is YOUR ENEMY late in your career. For each year that passes before you start on your journey, you will need to save more and more and it will have to grow faster and faster. Faster growth in a shorter time period requires more risk and a greater probability of loss.
So, don’t wait! Get going NOW!
Someday 35 years down the line, you’ll thank yourself as you reach financial independence while others are struggling to build their retirement late in the career, similar to many baby boomers now.
Now get to work! Good luck and Carpe Diem.
