3 Reasons to Invest While Young
The conventional wisdom says to invest while you're young, and actually, this is true. When followed, investing young is actually one of the easiest and best ways to ensure you build wealth. Why? Three main reasons:
Albert Einstein once said, “Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn't, pays it.” This is absolutely true. The most important thing about compounding is that it takes time. If you don't have time to let your money compound, your savings rate matters much more than your interest rate. If you have time, your savings rate matters much less in terms of meeting your goals.
To illustrate the point, let's say I want $500k to buy a beach house by the time I'm 55 and I'm 30 right now. If I know I'm really going to want to buy the beach house in the future, and decide to buckle down and start investing for that future purchase now in a portfolio with an average annual expected return of 8%, I only have to invest $550 per month which is $6,600 per year for the next 25 years. At age 55, I'd have invested $165,000 of my own money and the market would have done all the rest of the work for my beach house purchase. The market would be financing $335,000 or 67% of my beach house purchase. You might be thinking, “But how do you know if you will still want the beach house at 55? A lot can change in 25 years.” Yes, yes, it can, but you know what? There's nothing forcing me to use that $500k for the beach house at 55. I can use that money for whatever I want, but the key is I only had to put away $165,000 to spend $500,000. It's basically magic. If I can put away $1,100 per month over the same time period, I'm a millionaire. Plain and simple. No matter how much I make per year, no matter what my income, if I can manage to consistently invest roughly $250 per week I'll be a millionaire in that scenario.
But let's look at the flip side. Let's say I prioritize other things and figure I'll just catch up later. I blink and I'm 50. My kids are in college, I'm closing in on retirement age, and I still want the beach house. Assuming I can still average that 8% average annual return over the next 5 years, I'd have to invest $6,854 per month (which is about $82,248 per year) in order to have the $500k to buy the beach house on time. Now, we know that the market doesn't quite work like that in terms of returns on a short time horizon, but that's besides the point. In this case, if you did get that return you'd still have to have invested $411,240 of your own money, month by month, consistently over those 5 years to get that final result. Yes, it's SO nice that the market even in this 5 year example would have financed $88,760 or 17.75% of your beach house purchase If you can average that 8% return, but if you aren't investing anything before age 50, what's the likelihood that you'll be willing, able, and disciplined enough to find and invest $6,854 per month over the next 60 months? It's really unlikely. And that leads me to my next reason investing while you're young is so important.
The Power of Habit
A large part of why it's so important to invest while you're young is in the value of forming the habit. If while you're in some of the lowest earning years of your life and the furthest from working towards many of the tangible savings and investment goals that motivate older investors, you can manage to get in the habit of investing consistently anyway, you're much more likely to keep up the habit. Furthermore, when you're young, there are typically fewer responsibilities fighting for your dollars. Yes, there are outliers, but in general, financial responsibilities tend to increase over time. When you're working a high school or college job, I'm fairly confident in saying that the majority of these earnings for many American kids aren't going towards feeding or providing shelter for their households. It's going towards wants. Which is fine- there's nothing wrong with that. But that provides a perfect opportunity to start saving a bit. One less outfit from the mall, one less cocktail at the bar, one less lunch out with friends. It doesn't have to be a lot of money to build the habit. But doing so can pay huge dividends. Which leads into my next point.
Consistent investing over time at any level, but especially with small amounts while you're young can help build one of the most important assets to building overall wealth: momentum. When you start investing with less time to meet your ultimate goal, investing in the market can be scary and feel like the stakes are higher. Investing $25 per month, you probably won't lose sleep at a 30% drop. It's $7.50. It's easier to have the belief that your portfolio will bounce back and the tolerance to wait it out. It's also easier to invest like the money is gone. Investing $2,500 per month and seeing $750 disappear from your portfolio as a first time investor can halt your momentum very quickly. Even if you rationally know that the market tends to trend up over time, it can be really difficult to continue to add to your portfolio at a meaningful level in a downturn. It's a significant chunk of income, one you can probably imagine hundreds of other things you could spend it on no matter what your income level is. Experiencing market downturns and upswings at a lower savings rate when the stakes are lower helps increase your confidence in investing and in my experience increases the likelihood that you'll not only feel comfortable investing at a higher level when the time comes to invest for bigger longer term goals, but should also increase the related excitement and desire for continued investing.
Now, one of the biggest mistakes I've seen with younger investors is thinking they're invested when they aren't. If you open an investment account, but your holdings are in cash or some kind of money market fund, you aren't actually invested. You are basically in a savings account that looks like an investment account and you really won't reap the benefits of compounding or momentum as explained in this article, though you may still build the habit of consistently adding to the account over time. If you find you've done this, that's okay. Now is the perfect time to change that and finally invest your money. My best recommendation is to keep it simple. You don't need to buy 10 different funds or have accounts at multiple different institutions. You can buy one index fund and be diversified.
For 3 tips to keep in mind when investing, check out this blog post.