Loyal blog readers and radio show listeners of Van Wie Financial know that one of my favorite topics is the numerous threats to your retirement. Today’s topic is young people, and two major threats to their future financial independence. Both threats are self-induced, and come from their own behavior.
The first threat to future financial independence is obvious – saving too little, and for too little time. Starting young to build a retirement fund allows the magic of compounding to take place over a long time period. Anyone who looks at a curve of compound interest knows that the real buildup occurs after about the 20th year. It is the early savings that will transform small money into large money through compounding over time.
The second, and more complicated, threat to financial success is the tendency of young people to take too little risk. This is not intuitive to many people, because we have an insufficient understanding of the term risk (when applied to investing). For many people, the term “risk” implies that your money may be gone one day, having fallen prey to people hawking products and/or offering dubious recommendations. While that usage is viable, the term “risk” plays a much different role in portfolio design.
The stock market is risky. We all know that. The bond market is also risky. Less people know that. To understand risk in the investment markets, we need to understand that this definition of risk refers to variability of returns. We also must understand the risk is two-sided; investments can return less than expected in any given year, but investments can also return more than expected in any given year. That variability is the very definition of investment risk.
Money market funds are less risky than bond funds. Bond funds are generally less risky than individual bonds. Individual bonds are generally less risky than stock funds. And stock funds are generally less risky than individual stocks. Knowledgeable savers construct diversified portfolios, selecting assets from many asset groups, or classes.
Far too often, young savers tend to put their savings in bank accounts and/or money market funds. These assets carry very little risk, but therein lies the problem. The lack of true investment risk in their accounts prevents the upside of risk (higher returns) from happening. Long-term earnings and growth are suppressed, so the compounding factor is stymied.
Understanding investment risk will generally result in the design of a more productive portfolio. Taking more portfolio risk is the key, and understanding the importance of this risk is the facilitator. Education is critical to success.
One of the goals of the Van Wie Financial Hour is to keep you educated and informed about the dangers that lurk in the information-saturated media. We strive to be objective and consistent in the pursuit of financial independence for all who strive to achieve that goal.
Young people – save your money and take some risk. The rewards are substantial, and easily accomplished, once the young investor overcomes his or her own self-induced reluctance. Get started.