Advice for 20-Somethings: How to Make a Good Financial Start Even Better

July 22, 2009

Dear Carrie,

I'm a 24 year-old single college graduate. I was fortunate to graduate debt free, and have a job that pays roughly $40,000 a year in a part of the country where the cost of living is relatively low. While I feel this is a great start and that time is on my side, I know there’s more to do. I have begun to invest through my company's retirement plan and HSA offering; however, I have a savings of $10,000 to invest on my own, most of which is currently sitting in a checking account. I want to take advantage of my youth and invest aggressively. Yet, I don't feel that I have the capital to properly diversify without facing a bunch of upfront costs or tax penalties. What are my options?

— Sarah

Dear Sarah,

First of all, kudos! By contributing to your retirement plan and being debt free, you’ve already given yourself a great start.

With those things under your belt, the next thing to think about is an emergency fund – and it sounds like you’re in good shape there, as well. I generally suggest that everyone set aside enough money to cover three to six months of nondiscretionary expenses (in other words, just enough to cover things like rent, groceries, and insurance) in case of a job loss, illness or other unexpected event. Ideally, this money is liquid and FDIC-insured: for example, in an interest-bearing savings account.

It’s possible that most of your $10,000 of savings will have to go towards this emergency fund, but once you’re got that secured, here’s what I’d suggest:

Continue to make retirement a top priority. 
If you can, consider putting 10% of your salary towards retirement. If you can keep contributing at this rate for the next several decades, you should be in good shape once it’s time to retire. (A caution, though, to other readers: If you wait until later in your life to start saving for retirement, this percentage will likely need to increase considerably.)

The easiest way is to use your company retirement plan, taking full advantage of any match your employer might provide. (You wouldn’t want to leave what is essentially “free money” on the table.) If your employer offers a Roth 401(k), this might be something to consider because even though the money is not tax-deductible now, ultimately your withdrawals will be tax-free – a real benefit since you will likely be in a higher tax bracket when you retire.

It’s also great that you’re taking advantage of your Health Savings Account; just be sure you understand the particulars of your plan. Many HSAs only offer a fixed 2-4% return, but others allow investments in mutual funds and individual stocks. Your money can grow tax-deferred and, if it isn’t used to pay for medical expenses, it can stay in the account and keep growing indefinitely. At 65, you can withdraw the money without taxes or penalties. 

Then identify and start saving toward shorter-term goals.
Now you’ve got a choice. You can either contribute more to your retirement account (the current maximum is $17,000/year to a 401(k), or up to $5,000 to an IRA) or you could decide to start saving for other goals. What’s next: A home? A graduate degree? A vacation? This is a highly personal decision, and there’s no one right answer.

Whatever you decide, think about opening a brokerage account, which will give you access to many more investment options than your savings account. In addition, I suggest that you consider setting up automatic contributions to your brokerage account (a lot like what you already have for your retirement plan). That way you can spread out your purchases over time – otherwise known as “dollar-cost averaging.” By investing the same dollar amount every month (or at any regular interval) you automatically buy more shares when prices are cheap, and fewer shares when they’re expensive. Over time, your average share cost (what you actually spend) can wind up being lower than the average share price. Of course this approach doesn’t guarantee a profit or prevent loss (nothing will), but it does help you remove emotions from your investing decisions, and give you the structure to invest consistently over time. 

Think about your time frame and risk tolerance.
History shows that over the long term, stocks have been the best defense against inflation. But the hitch, as we’ve all witnessed, is that the stock market can be extremely volatile. I’m a big advocate for the long-term advantages of investing in the stock market, but only if you know you can stomach the ups and downs and have a long time horizon. Money that you plan to spend in the next three to five years should not be in the stock market.

And as you suggest, diversification is key. Trying to pick a winning stock is like trying to pick a winning team. Sometimes it works, but often it doesn’t. That’s why it makes so much sense to spread out your money among several companies of different sizes, in different industries, and in different parts of the world.

Broad-based mutual funds or exchange traded funds can be a relatively easy and cost-effective way to do this. But you have to do your homework! As you mention, fees can easily erode your return – so not only do you want to look for highly rated funds, but also stick with funds that have no up-front costs (“no-load”) and low operating expenses. You’re also wise to think about tax implications, especially when you’re buying mutual funds in a taxable account.

Get a little more help.
And finally, think about having a portfolio consultation. As you build your assets, it’s a good idea to sit down with a trusted advisor who can speak to you in more depth about the most cost-effective way to build a portfolio that matches your goals and time frame. When you meet with an advisor, never be shy about expressing your opinions or asking questions. After all, this is your money, and you deserve to be in control.

Best of luck and keep up the good work!

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Exchange Traded Funds are subject to risks similar to those of stocks. Investment returns will fluctuate and are subject to market volatility, so that an investor's shares, when redeemed or sold, may be worth more or less than their original cost.

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