It happens. At some point you just realize your financial life is underway. You’ve learned to keep debt in check, created an emergency cash reserve in case you encounter any future employment gaps…now what?
“I see a lot of people stuck on how to start investing,” confirms Sophia Bera, CFP® and Founder of Gen Y Planning. “Once people have taken care of their high interest rate credit card debt, figured out a plan for their student loans, and have set aside money for emergencies, investing is a great next step,” she adds.
If that describes where you are in your financial life, here are four pointers to help you succeed in taking that next step.
#1 Remember that tax-free is better than tax-deferred
Investing in your employer’s 401(k) plan to the extent you maximize your opportunity for a matching contribution is a good first step. But Bera advises taking this step in tandem with opening a Roth IRA.
While a 401(k) offers you a tax-deferred way to invest, a Roth IRA—assuming you follow the rules—can offer you more than tax deferral on your retirement savings. Your distributions at retirement can be tax-free. Instead of saving on taxes now and paying later, a Roth IRA enables you to pay taxes now—presumably while you are in a lower tax bracket—and you are done. It doesn’t matter how much your account appreciates over the ensuing decades, the current tax law offers a shelter from taxes.
But, that sheltered savings is likely to be unnecessarily stunted unless you invest for appreciation. In other words, put your money in something other than a short-term, cash-like investment.
#2 Know your enemy: It isn’t market volatility, it’s inflation
“One of the biggest issues for Millennials is their lack of understanding regarding the nature of investment risk. But, if people aren’t willing to take some risk, especially with their retirement assets, then inflation will outpace their investment growth, which could be a huge problem for my generation,” says Bera.
A study conducted by UBS, the global financial services company, found that many young adults appear to be trying to build wealth slowly…too slowly. The study’s respondents are shying away from investing—in homes, stocks, and bonds—and building cash balances for fear of volatile valuations, which they are confusing with minimizing risk.
While such a conservative approach limits the risk of experiencing market price fluctuations, it opens the door to a greater risk: inflation. Even modest inflation can significantly reduce purchasing power over time, and that greatly diminishes the effectiveness of your savings when you are ready to retire. Even if your goal is simply to hang onto what you keep, you are likely to be better off shifting your focus from short-term market moves. Instead, look for ways to earn rates of return that are likely to keep up with—and preferably exceed—the rate of inflation over the long run.
#3 An easy strategy for facing down the fear of market volatility
When fear is the issue, a dollar-cost averaging strategy offers a simple fix. In fact, if you are diverting a small amount from each paycheck into your employer’s retirement account now, you are already doing it.
Dollar-cost averaging involves making regular investments over time, regardless of market conditions. The logic is that it keeps you from over-committing when markets are overpriced and optimism is high and forces you to buy when markets have fallen and fear is rampant. Because you commit to a routine, you can keep your emotions out of the decision of when to invest.