Updated: 1/6/2010 10:34 PM ET|
Time is money: Start young
Many adults play a futile game of catch-up as they realize their savings are insufficient for retirement. It's never too early to begin managing your finances.
By age 14, Damon Williams had built a portfolio worth $50,000, knew blue chips like most kids know potato chips and saved more money than he spent. Is this Chicago teen an investing freak of nature? Quite likely. Even so, most of us could learn a thing or two from him.
The longer you're able to keep your money in the market, the more likely you are to make big bucks investing in stocks. Damon's smart use of his Christmas-present cash demonstrates a few of the many reasons this is true:
- By starting early, your investing dollars have a better chance of surviving your mistakes and the market's gyrations.
- The best time to develop good financial habits -- such as living within your means and saving little bits at a time -- is when you're young.
- You don't have to get every investment right to win in the market. Not everyone can be -- or needs to be -- Warren Buffett. You just need to be prudent and get started.
Room for improvement
Such lessons aren't as obvious as you might think. Experts warn that our nation's future is in peril owing to a dangerous lack of basic financial education at a time when the financial landscape grows increasingly complex. The Jump$tart Coalition for Personal Financial Literacy in Washington, D.C., recently found that less than 50% of high school seniors passed a basic financial literacy test, and just 62% of college seniors passed the same test.
These rates translate into poor money management habits in adulthood. A survey by the National Foundation for Credit Counseling found that 26% of American adults do not pay their bills on time, one-third have no savings and one-third do not contribute to retirement funds.
Recent high school and college graduates are especially at risk of living beyond their means and failing to invest -- dangerous habits at any age but especially for those starting out, says Michael Rubin, a certified financial planner and the author of "Beyond Paycheck to Paycheck: A Conversation About Income, Wealth, and the Steps in Between."
Start now or pay later
"A lot of people feel they'll just save more later, when they have more money, and theoretically that's possible," Rubin says. "But few people realize how much more they'll have to save than someone who got their act together in their early 20s."
Or earlier. Damon sets aside $20 a month for investments and saves up until he is ready to make buys -- usually the stocks of blue-chip companies such as Walgreen (WAG, news), Coach (COH, news) and Verizon Communications (VZ, news).
But you don't have to start at age 5 to get a jump on the game. A 21-year-old who saves $300 a month -- just $10 a day -- at a return rate of 8% will have a pot of gold of $1.5 million by age 65. If that person waits five years until age 26, he will have to save 50% more every single month for nearly 40 years to catch up.
This example dramatically illustrates the principle of time value of money. Time value of money means that funds invested over time are compounded, so that even small sums steadily set aside can grow to impressive amounts. This happens because of a key concept: compound interest. This means that interest is calculated not only on the original investment but also on the interest that has already accumulated. Compound interest also means that your investment will grow faster.
Another critical reason to start investing at a young age is that the longer you hold your portfolio, the better the chance of withstanding market fluctuations. Because most investments go up and down in value over time -- but historically increase in the long term -- the longer you are in the market, the better the chance that you will come out ahead. A long-held portfolio also buffers against investor mistakes -- mistakes that everyone makes along the way.
"The longer you save and invest money, the more you reduce your risk," Rubin says.
Starting early minimizes risk
Starting earlier means fewer risks as you get closer to retirement age. To compensate for a late staret, someone who starts investing at age 40 needs to average nearly three times the return of someone who starts at age 20, all else being equal. If the 20-year-old averages 8% per year on his return, the older person would need to average 23% -- nearly impossible considering historical averages.
Trying to generate those bigger gains usually means taking bigger risks and continuing to take them as you approach retirement, precisely when a person should be more conservative with investments.
The first step is to save and invest -- and not spend so much energy worrying about how to invest, Rubin says. Putting your long-term savings into what mutual fund companies market as target-date funds is not a complicated process. Target-date funds are mutual funds that have a pre-determined mix of stocks, bonds and other assets that are aggressive (having a higher proportion of stocks) when a person is decades away from retirement and grow more conservative (typically adding more bonds) as the investor nears retirement. Many investors like them because they require little involvement once purchased.
"We're not talking about investing in a way that will rival you with Warren Buffett," Rubin says. "Most people get hung up on how to invest their money, but they don't spend enough time figuring out how to save enough."
Damon spends a lot of time on investing -- after all, this is his hobby. The teen's investing career was launched when he begged his mom for a new pair of Air Jordan basketball shoes. Instead of shelling out for yet another pair, she persuaded him to save up to buy a share of the shoemaker's stock.
"I made him excited to be an owner of a piece of a company," says April Williams. In fact, Damon says, this excitement beats other activities, even playing video games.
Though it's not realistic to expect your kid -- or yourself -- to be a financial guru like Damon, it is critical to teach children about financial basics -- for both their own and the nation's future, says Laura Levine, the Jump$tart Coalition's executive director.
"There's not a magic age (to begin financial education)," Levine says. "But investing is something that young people have the intellectual ability to understand. Even as we get more financial education in schools, it's important for parents to continue the discussion."
Financial literacy resources for parents:
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