Millennials haven’t had it easy. Growing up, the generation born between 1981 and 1996 experienced the attacks on Sept. 11, subsequent wars, the worst recession since the Great Depression, a student loan crisis, and a pandemic. It’s understandable why saving and investing for retirement may not have been their top priority.
However, with most millennials now having completed their education and gained a few years of work experience, many are at an age where they can and should start thinking about investing to achieve long-term financial goals.
Let’s explore some investing basics and why it’s important to get started.
Why It’s Important for Millennials to Invest
If you witnessed the 2008 financial crisis or are impacted by the market downturn in 2022, you might see investing as risky. But not investing carries risk too.
“The worst thing you can do in your mid-20s to mid-30s is not save money and invest. If you invest money early on, it gives your money a long time to grow,” says Mike Kerins, head of advisor products at Apex Fintech Solutions. He notes that despite market ups and downs, it’s rare for the stock market to stay down for a long time.
Stock investments deliver bigger returns over cash and bonds in the long run. Money in savings accounts is stagnant and affected by inflation, whereas stock market investments can grow over the years. For example, large capitalization stocks returned roughly 10 percent compounded annually from 1926 to 2020, while long-term government bonds returned about 5.5 percent annually, and T-bills around 3.3 percent annually.
“The surest way to build wealth over long time horizons is to invest in a diversified portfolio of common stocks,” says Robert Johnson, professor of finance at Creighton University and chairman and CEO of Economic Index Associates.
Another advantage of investing over time is the snowball effect.
“Millennials need to begin compounding early and let that compounding work its patient magic over decades,” Johnson says. Compounding means that when you earn interest on your investments, you also earn interest on that interest. This helps you build a larger balance over time without adding extra capital.
For example, if you invest $6,000 per year starting at age 25, and earn $100 in interest that year, at age 26, you’d earn interest on $6,100, then on $6,300, then on $6,600, and so on. Over time, you’d see a much larger return compared to just saving that money in a savings account.
Learn the Basics of Managing Your Investments
Risk Tolerance: Before making your first investments, understand your risk tolerance. This refers to your ability and willingness to handle investment losses, which might be temporary or permanent. While the stock market tends to rise over the long term, it can experience severe declines over shorter periods. Consider if you can handle these periods of decline or if you might prefer safer investments.
Asset Allocation: As you build your investment portfolio, decide how much should go toward stocks versus other assets like bonds or real estate. Assets can be further divided based on geography, investing style, or type of company. This mix is called your asset allocation and will likely shift from mostly risky assets early on to safer assets as you approach retirement.
Active vs. Passive: Decide whether you want to be a passive or active investor. Active investors try to beat popular market indexes like the S&P 500 by picking companies they think will perform well. Passive investing, or index investing, aims to match the performance of broad indexes and typically costs less. This cost savings has often led to passive investors outperforming active ones over long periods.
Diversification: Diversification means spreading your assets across different investments, recognizing that some will perform well while others may not. Broad diversified portfolios have performed well over time.
Time Horizon: Knowing your time horizon is crucial. Identifying key goals, such as saving for retirement or a child’s education, will impact how you invest. Long-term goals, at least five years away, usually involve owning long-term assets like stocks. Short-term goals, like saving for a down payment on a house, are better served by safer assets like a high-yield savings account.
Most Common Types of Investment Accounts
IRA: An individual retirement account (IRA) allows you to save for retirement with tax advantages. Money in an IRA can grow tax-free, leading to higher returns than if you paid taxes along the way. Contributions are made pretax, possibly lowering your tax bill today. Withdrawals can begin at age 59½, at which point you’ll pay taxes on the money you take out.
Roth IRA: Similar to a traditional IRA, a Roth IRA has key differences. Contributions to a Roth IRA are made after taxes, so there’s no immediate tax benefit. However, when withdrawals begin at age 59½, you won’t owe any taxes. The Roth IRA is one of the best ways to save for retirement because of this tax advantage. Early withdrawals from both Roth and traditional IRAs usually come with a 10 percent penalty.
401(k): A 401(k) is a popular workplace retirement plan that allows employees and employers to set aside a portion of earnings for retirement. Many employers match employee contributions up to a certain amount, which is important to take advantage of because it’s like free money. Contributions grow tax-free, but withdrawals, typically beginning at age 62 or 63, will be taxed.
Brokerage: A brokerage account lets you invest in securities like stocks, bonds, and ETFs. Brokerage accounts are taxable, meaning you’ll pay capital gains tax on any realized gains. If you’re maximizing retirement savings through accounts like 401(k)s and IRAs, a brokerage account can be an additional way to build wealth. Many online brokers offer free trading commissions, and you can access your money without penalties.
These are just a few popular types of accounts, but there are others worth knowing about.
Best Investments for Millennials
Stocks: For millennials, most investing goals will be long-term, like retirement, best achieved through owning long-term assets like stocks. A stock represents partial ownership in a business, and over time, the stock will perform similarly to the business. You can invest in stocks individually or through ETFs and mutual funds.
Index Funds: Index funds are mutual funds or ETFs that aim to match the performance of an index like the S&P 500 or the Dow Jones Industrial Average. Index funds can invest in stocks, bonds, or real estate. Because they are passively managed, they typically have very low costs, leaving more return for investors. Index funds are a great way to build a broad diversified portfolio with minimal fees.
ETFs: Exchange-traded funds (ETFs) hold a basket of securities and trade throughout the day like stocks. You can invest in stock ETFs, bond ETFs, commodity ETFs, and more. Many ETFs are passive and track indexes like the S&P 500 or the Russell 2000. ETFs can be a great way to build a diversified portfolio even with limited funds. Unlike mutual funds, ETFs usually don’t have a minimum investment.
Mutual Funds: A mutual fund pools money from investors to invest in a group of securities like stocks or bonds. Your investment in the fund mirrors the overall fund’s investments. Unlike ETFs, mutual funds trade once a day at the closing net asset value (NAV) price. They can be purchased through a broker or directly from the fund company and usually have a minimum investment of a few thousand dollars. A fund’s returns depend on the performance of its underlying assets.
Bottom Line
It’s understandable why investing for retirement may not have been a top priority for millennials. But now is the time to start investing and take advantage of the power of compounding. Despite market fluctuations, investing in a diversified portfolio of stocks has proven to be one of the best ways to build long-term wealth. Don’t miss out on the potential for a snowball effect over the years that could greatly benefit you financially in the long run.