One reason it’s important for your kids to start investing at a young age is risk.
You may have heard that with investing you’re able to take more risks when you’re younger than when you’re older.
But what does that really mean?
Sure, at face value, it means investing in higher risk, more aggressive things, like choosing an all-stock mutual fund over a stock/bond mix.
But there’s more to it than that. A larger part. Let’s talk about that part.
“You can take more risks when you invest young” is blanket advice.
So first, a word on blanket advice…
With my coaching clients, I typically tell them to use the stock market to grow money they won’t need for at least five years and to use something more conservative (e.g. savings account, municipal bonds, etc.) for money they’ll need earlier.
But then a question like this comes up: “if I need that money in six years, do I just invest aggressively for the first year and then transition into a savings account?” “If that’s the case, what happens if my investment dwindles in the first year? Do I still take the money out?”
While that’s the idea, like with most financial issues, it’s not that simple.
This is where age comes into the equation.
I’m not a big fan of the “formulas for everyone,” because we’re all in different situations. That’s why personal finance is personal.
Here’s a popular example: “subtract your age from 100 and hold that percentage of your portfolio in stocks, while holding the rest in bonds.” In this example, a 30-year-old would own 70% stocks and 30% bonds.
That formula may work for some people, but I know more than a few 30-year-olds who would rather have more than 70% in stocks. I was one of them.
These formulas rarely apply to everyone’s situation.
So how does this apply to what we’re talking about? Flexibility…
The #1 Benefit of Investing Young
Younger people can take more risks, such as having a higher percentage of their investments in stocks as opposed to bonds, but that’s not really the main thing.
The main thing is choice and flexibility.
The only way I know to explain this is through an example. Two examples actually…
Example #1: Playing it Safe
Let’s say this same 30-year-old we’ve been picking on wants to save for a house.
He wants to pull the money out for his family’s home in four years, so he and his wife play it safe and use a savings account. They’ve been working hard to earn extra income and are able to save $1,000/month.
At the end of the four years they will have saved $48,000, and with their savings account interest, they will have earned around $360, assuming a 0.5% interest rate (fairly standard rate).
In total, they have $48,360. Not much more than the amount they saved. So now, at age 34, they can buy a small fixer-upper in some states or apply a decent down payment in other states.
Example #2: Taking a Risk
Let’s say this 30-year-old decides he doesn’t like the sound of example #1, so he opts for a riskier path.
He still plans to pull the money out in four years, but instead of a savings account, he uses an S&P 500 index fund (a fund that distributes your money across the largest 500 companies in the US). Risker, but more potential for reward.
Assuming he earns the fairly conservative average of 8%/year, at the end of the four years, his family will have $54,073 to spend on their home, contributing the same $1,000/month, or $48,000 total. If the market performs above average—around 16% for the four years—which isn’t totally unheard of, they’ll have over $60,000.
All of that would be ideal, but what if the market crashes a year after they start investing for their home? This is where it pays to be young. At 34 years old, they have plenty of time to come back from a loss and still get to that $50,000-$60,000 range, assuming they don’t freak out and pull all of their money out.
Therein lies the main benefit of being young: they can stay flexible.
If they would’ve been in their early 60s when they started, they may not have the time to wait one, two, or ten years to accumulate the money they need for their home.
Young Means Flexible
When you’re young, you’re flexible in what you can afford to invest and what you can afford to lose. Since you don’t really lose money in the stock market until you pull the money out,1 younger people have time to wait it out.
They have time to change their plans and make new ones.
When you’re young, it pays to avoid sticking with an exact path, and to be willing to make adjustments when things don’t work out.
The ability to stay flexible is a greater benefit than merely investing in more aggressive funds. The ability to stay flexible is the key to earning more on investments. It pays to have a Plan A, B, C and so on.
The most important thing with investing is starting young, because time is what leads to successful investing. If you don’t believe me, just read these 8 reasons you should start investing in your 20s.
Further Book Reading
- It’s true that you don’t lose money until you cash out, but beware because this can be a dangerous mindset when investing in individual stocks. People will watch their stock deteriorate, because they were “waiting for it to come back.” I’m not encouraging this behavior. I’m referring to investing in index funds, where historically, it will come back. It always does. Eventually.