Lifetime Investing - Begin as a Kid
Many people begin serious investing in the stock market when they reach their forties and fifties. With retirement coming in a few years they attempt to play catch up and hope for large returns to fund their retirement nest egg. To this end more than half the families in the United States are invested in the stock market. Why do they choose to own stocks? Because for the last 100 years the returns from the stock market have outpaced other popular kinds of investments like bonds and certificates of deposits.
But the stock market doesn't go up every year. In fact there have been periods when the stock market went down for several years or was flat for many years. If you are middle age and happen to invest during an off period, you may not accumulate enough money in your stock portfolio to fund your retirement. However, if you invest at a very young age and hold your investments for a long time, say 40 or 50 years, you can counteract the ups and downs of the market and you will have a very good chance of making lots of money. The secret is to invest for a long time.
The message of this article is to start investing at the earliest possible age. With a rising long-term stock market and many years of investing, you are almost certain to achieve large long-term returns. For example, $1,000 invested each year in the United States stock market from 1954 to 2003 grew to $537,493 as of June 25, 2004. So a $50,000 investment grew 10 fold. This simple example shows that you don't have to be wealthy to make money in the market. You simply need a modest amount of money, discipline to invest regularly and lots of time. Obviously no one knows what the future will bring for the stock market but if you assume the long-term future will be somewhat like the last 50 years, you should make lots of money investing in stocks.
This article is written for teenagers and young adults and their parents may be interested in it as well. The purpose of the article is to convince young people to start investing while in high school or before thus ensuring a financial secure retirement. The article gives young people step-by-step instructions how to prepare a savings and investment plan, open an individual retirement account, select a low-cost financial institution to house the account, select safe stock investments, and make systematic investments.
Just imagine how much money you could accumulate if you started a systematic savings and investment program when you are 18. And then you continued the program throughout your adult life.
Where Does a Young Person Get Money to Invest?
Teens and young adults have lots of money at their disposal. Many receive a regular allowance from their parents. Many have part-time or full-time jobs. Most kids receive money from their parents and relatives on birthdays, special religious celebrations and holidays. Some are given money for academic and other achievements. Often high school and college seniors receive money as a graduation present. And cash gifts are common as wedding presents.
In our affluent world teens and young adults are consumers like all of us. So they tend to spend much of the money they receive and earn. Most young people spend lots of money on clothes, food and entertainment. Many own cars and others have expensive hobbies. Some are in college or on their own and pay rent and utilities.
Although saving money may be difficult, it's very important that young people become regular savers and investors. Because they have lots of time of their side, their investment dollars have the potential of making huge gains.
How to Begin a Lifetime Investing Program
The following list is your guide to profitable investing for a lifetime:
- Start a systematic savings program at the earliest age. Park the money in certificates of deposit until to start buying stocks.
- Begin making contributions to a Roth IRA as soon as you earn taxable income from a part-time or full-time job.
- Own shares of the 500 largest companies in the United States by owning the Standard & Poor's 500 stock index (S&P 500) through index or exchange traded funds.
- Reinvest all dividends you receive.
- Set up a systematic schedule of contributions.
- Hold your shares until you retire.
Each of the steps is easy to understand and implement. The following discussion gives you specific recommendations and instructions how to construct your lifetime investing program.
Start a Savings Program
Before you can invest your money for the long term, you must have the money to invest. Many people spend their money so quickly that they don't have any left to save and invest. You want to learn how to avoid the no savings trap.
To save money requires that you discipline yourself to set aside some percentage of you income, allowance and monetary gifts before you spend that money. As a start think about saving at least 10% of your income, monetary gifts and allowance. If you can save a higher percentage, that's even better. Remember that the more you save and invest at the earliest possible age, the more money you'll have in the future.
Follow these five simple rules to save money:
- Save first, then spend - make savings, not spending, your top priority.
- Save money every time you receive money - get into the savings habit, be a disciplined saver.
- Save as much as you can - even a few dollars saved is better than nothing saved.
- As your income increases, save more - save added income, don't spend it all.
- Save forever - continue to save even when you feel you have enough money. Because of inflation (rising cost of living) money doesn't go as far as you might think.
Finally, think about this idea: "Having money doesn't ensure happiness but not having money makes happiness more difficult."
Buy and Hold the Standard & Poor's 500 Stock Index (S&P 500)
recommend investing in the broad United States stock market as defined by the Standard & Poor's 500 stock index. The S&P 500 includes the 500 largest publicly traded companies in the U.S. Thus, it is a diverse mix of all types of companies like IBM, General Electric, Microsoft and Colgate that provide goods and services to the U.S. and the world. With the S&P 500 you don't have to attempt to pick a few stocks that may or may not do well. You can sleep well knowing that your diversified portfolio of 500 companies will protect you from a few bad apples.
As a shareholder of the S&P 500 you are entitled to benefit from the good fortunes of these companies so as they grow their businesses and profits, their stock prices will increase and you'll make money from this price appreciation. Some of the companies will generate excess cash and distribute it to shareholders in the form of cash dividends. You may take the dividends in cash or you may reinvest them and buy more shares of stock. I recommend that you reinvest the dividends.
The combination of dividends and stock price appreciation ensures that your long run returns will be greater than many other types of investments. Of course there will be periods when the stock market is doing well and some years when it's doing poorly. But over the long run you can expect the S&P 500 to rise in price.
Why Not Buy Individual Stocks or Popular Mutual Funds?
The U.S. stock market includes thousands of stocks and mutual funds. With all these choices available why do I recommend the S&P 500? My primary reason is because it is very difficult to pick stocks and mutual funds that have a better long-term performance (makes you more money) than the S&P 500. Most professionally managed mutual funds do poorer than the S&P 500 in the long run. Of course some funds do better but it takes lots of time and study to pick the winners. The same is true with individual stocks. If you pick a winner, you can make huge amounts of money in a short time. But you can also lose a lot of money very quickly if you pick a loser.
Set Up a Roth Individual Retirement Account (IRA)
The next step is to establish a retirement account at a financial institution where you can regularly buy the S&P 500 and keep some cash.
I recommend that you setup a Roth Individual Retirement (IRA) account. The U.S. government established the Roth IRA to encourage people to save for their long-term financial needs. The primary advantage of the Roth IRA is that you never pay any tax on gains that you achieve in the account. This tax shelter feature is a boon to investors because taxes take a big chunk of your investment returns.
You may set up a Roth IRA at any age when you begin to receive earned income from a part-time or full-time job. Earned income is money you receive in wages, tips and salaries. Gifts and allowance money do not qualify as earned income. You can contribute $1 for each $1 of earned income up to a maximum of $4,000 for one calendar year. If you have no earned income for a year, you cannot make any contributions to your IRA for that year.
You may start to withdrawal money from the Roth IRA after age 591/2 and you'll pay absolutely no taxes on any gains you made on the your investments in the account. If you withdraw money before 591/2, you must pay substantial penalties. Remember that the Roth IRA is intended as a retirement buy-and-hold account for long-term investing. So if need money for immediate needs like school, travel, medical expenses, etc., do not put that money in your IRA account. Once the money is in the IRA account it should stay there until you retire.
Selecting the Financial Institution for Your Roth IRA
You may set up a Roth IRA at most banks, brokerage firms and mutual fund companies. I recommend that you select a financial institution that:
Offers the S&P 500 - some institutions do not offer the S&P 500 as an investment option.
Charges very low fees - fees can substantially reduce your returns.
Offers automatic investing - you may want to make automatic investments each month or another time interval.
How to Buy the S&P 500
You can buy the S&P 500 through a special type of mutual fund called an index fund that mirrors the return of the Standard & Poor’s 500 stock index. The index fund is not managed by a professional manager so it is very inexpensive to run compared to a managed mutual fund that require hands on buying and selling of stock.
A low fee index fund that tracks the S&P 500 is the Vanguard 500 Index Trust Investor Shares. It owns the 500 companies that comprise the S&P 500. You can buy the Vanguard 500 Index Fund Investor Shares directly from the Vanguard Group, a leading low-cost mutual fund company.
Another way to own the S&P 500 is with an exchange traded fund (ETF), which you may buy and sell like a stock. The exchange traded fund that tracks the S&P 500 is called the SPY. You can purchase shares of the SPY from any brokerage firm. You will pay a small commission to buy the SPY and another small commission to sell it. But, unlike a mutual fund, you will not pay any annual fees to own it in your account.
Either the Vanguard Index 500 or the SPY is appropriate for any retirement account.
Minimize Your Account Fees
All retirement accounts are subject to fees charged by the financial institution. Try to minimize these fees because they add up and will reduce your total return. Even seemingly small fees can have a significant impact on your total returns. The types of fees include: setup fee to open the account, transaction fee to buy and sell an investment, annual fee to maintain the account, inactivity fee for an account with few or no transactions, redemption fee for withdrawing money and transfer fee to transfer your account from one institution to another. Also, many accounts have a minimum dollar amount required to open an account.
Before you open an account, take time to understand the fee schedules.
Reinvest All Dividends
A company that generates excess cash that it doesn't need for operations often distributes that cash to its shareholders in the form of cash dividends. Many of the 500 companies that comprise the S&P 500 stock index pay dividends. Therefore, the Vanguard 500 Index Trust Investor Shares and the Spy pass along dividends to their shareholders. For example, on May 26, 2004 the Vanguard 500 Index Trust Investor Shares paid a $0.36 quarterly dividend for each share that an investor owned. If you owned 1,000 shares, you would have received $360 in dividends. Because the fund pays a dividend four times each year you would expect to receive approximately $1,400 in dividends for the year. If you owned 100 shares, you would have received around $140 in dividends for the year.
You may receive the dividends in cash or you may reinvest them and buy additional shares. I recommend that you always reinvest the dividends. With them you increase the number of shares you own without contributing any new money to you account.
Set Up an Automatic Investing Program
Discipline and convenience are the keys to regular savings and investing. When you have a steady stream of earned income from a part-time or full-time job, you can decide to regularly invest a fixed amount of money to your Roth IRA. For example, you could contribute $100 each month. The most convenient method to invest regularly is to set up an automatic transfer from your checking or savings account to your Roth IRA account. Most IRA accounts let you set up the transfers online. So in a few minutes you simply specify the dollar amount of the transfer, the day of the month of the transfer and your bank account information (routing and account numbers).
With automatic investing you add new money to your IRA at regular intervals. This means that when you invest new money, you will be buying the S&P 500 at different prices. When the market is down, you'll buy more shares than when the market is up. This process is called dollar-cost averaging because the cost of all your shares is the average of what you paid for each share. Some shares were cheap and some were more expensive. Dollar-cost averaging is a simple way of systematically investing for the long-term.
What Can Go Wrong with Your Investing Plan?
So what could go wrong with the lifetime plan of investing in the entire stock market using the S&P 500? The worst-case scenario would be for the U.S. economy to crumble for a long period just before or during your retirement. In this case your portfolio would lose value when you needed to withdraw money.
If you were concerned that a prolonged downturn was coming, there are investment tactics that you could execute to protect your portfolio from serious losses. The simplest would be to sell some of your stock and keep the proceeds in cash. You probably would not make much interest from the cash but you would not lose a lot of money if stock prices were to fall.
But, obviously, no one knows what economic conditions will be in 50 years. So at a young age you should be more concerned about saving and investing today rather than worrying about what could happen in 50 years.
Start investing early in life, set up a Roth IRA, invest as much as you can each year until you retire, bet on the entire market - not on individual stocks, invest automatically, reinvest dividends to buy more shares and keep your investing costs to a minimum.