Financial Lessons for a Younger Self: Six simple lessons for a young investor to get a head start on saving for retirementSubmitted by Ullmann Wealth Partners on July 29th, 2021
Author: Pat Kilbane, J.D., CDFA®
July 29, 2021
We have had the opportunity to work with many young investors this year. This got me thinking about how I managed my finances when I was a young adult. What wisdom could I share with my younger self?
I thought about finances and saving for retirement as a younger self, but if the following lessons had been shared/reinforced more with me, I feel like I would be that much further ahead of the curve today.
1. If you don’t have it, don’t charge it
As young people, we are constantly told that we need a credit card so we can start “building credit." The truth is, you do not need credit until you are ready to borrow money to make a large purchase. I have seen so many young people use their credit cards and max out their credit limit without regard as to how they were going to pay the debt. These credit cards tend to charge outrageous interest rates on outstanding balances – most times north of 15%. Young people tend to only make minimum payments and end up accruing a significantly larger balance because the interest charge is added to the balance.
While building credit with a credit card is not a terrible idea, my suggestion is, if you are ready to obtain your first credit card, start with an extremely low credit limit and get in the habit of paying your balance each month. Otherwise, stick with a debit card until you feel comfortable with using a credit card.
2. Compounding interest is truly the 8th wonder of the world
How can you get your money to grow faster? I wish I fully understood the concept of compounding when I was much younger. Even saving as little as $25 per month will make a big difference long term, thanks to compounding!
What is “compounding?” Investopedia defines compounding as, “the process in which an asset's earnings, from dividends, capital gains, and/or interest, are reinvested to generate additional earnings over time. This growth, calculated using exponential functions, occurs because the investment will generate earnings from both its initial principal and the accumulated earnings from preceding periods. Compounding, therefore, differs from linear growth, where only the principal earns interest each period."
Think of a snowball rolling down a mountain. As it rolls, the ball continues to acquire additional snowpack and the ball is larger. The larger ball continues to add more snowpack, and the final product is a gigantic snowball that is exponentially larger than the one that started rolling down the mountain. With the money you have invested, when you reinvest the dividends, capital gains, and/or interest, the underlying balance becomes larger and produces more dividends, capital gains, and/or interest that are also reinvested.
The takeaway for the young investor is to keep your money invested and allow those capital gains, and interest to be re-invested – don’t take the earnings out of the portfolio.
3. Earn money while you sleep!
When I was in college, I became interested in personal finance. I read Robert Kiyosaki’s best-seller, “Rich Dad, Poor Dad.”Kioysaki contrasted his biological father as his “Poor Dad” who only derived his income from his paycheck. His best friend’s father, “Rich Dad,” on the other hand, earned income actively from his job, but also derived income “passively” from allowing his money to work for him. He aggressively invested a significant amount of his money to develop additional income streams so he could earn money while he was asleep. What a concept! He didn’t have to be at work to be earning money. The goal would be to work hard at developing enough “passive” income to replace your “active” income.
I highly recommend “Rich Dad, Poor Dad” to all young investors and to start to develop passive sources of income.
4. A $10 haircut is not really a $10 haircut
This next lesson is another way to discuss compounding interest. The famous American Investor Warren Buffett argues that a $10 haircut is much more expensive because you must consider the lost earning potential on that $10 if it was invested instead of spent on the haircut. Said another way, young investors need to think about the “opportunity cost” of their spending choice relative to what that $10 would have returned to them.
If that $10 was invested for 30 years and compounded annually at 10%, it would be worth almost $300,000 (Actually, $284,799 to be exact). So, Warren Buffet asks himself, “Do I really want to pay $300,000 for that haircut?
This is a great exercise for all young investors as they evaluate whether they can delay their gratification and invest instead.
5. Start taking advantage of your 401(k) as soon as possible
Most employers offer their employees a retirement savings account which is typically referred to as a 401(k) account. An employee will contribute to this account via payroll deductions. The investments in this account will grow tax free. Further, the amount the employee contributes to the account reduces their taxable income up to a certain amount.
One of the best features of a 401(k) is many employers will incentivize their employees by matching their contributions (for example, up to 3% of the employee’s salary).
Young investors starting their first job should contribute as much to their 401(k) plans as possible. For investors below age 50, the maximum 401(k) contribution is $19,500 annually.
6. Invest in a Roth IRA
Another helpful retirement tool is a Roth IRA account. Roth IRA’s are retirement accounts that are funded with after-tax dollars. The funds invested within the Roth IRA grow tax-free and are distributed tax-free in retirement. Unlike traditional IRA’s which mandate required minimum distributions (“RMD’s”) at age 72, Roth accounts do not require any withdrawals.
The maximum annual contribution to a Roth IRA is $6,000 for investors below age 50. Investors with taxable income can contribute to a Roth IRA if they meet certain income requirements. Specifically, investors who are married filing jointly are unable to contribute to Roth IRA’s at income levels above $208,000 annually. Single, head of household investors are not permitted to contribute at income levels above $140,000. Therefore, it is beneficial to fund Roth IRA accounts earlier in the career trajectory before reaching the income thresholds.
These are just some of the few tricks I learned over my investment career and would love to share with my then 18-year-old self. Any young investor that heeds this advice will really turbo charge the beginning of their investing career and bolster their retirement savings.
Pat Kilbane is the Director of Divorce Advisory Group, an affiliate of Ullmann Wealth Partners, and is also a Wealth Advisor. Prior to joining the firm, Pat practiced family and matrimonial law for nearly a decade. He had previously worked as a Shareholder for the statewide law firms Gray Robinson, P.A. and Rogers Towers, P.A.