4 Thoughts on Personal Finance and Investing that You Have to Know in Your 20s
Before you read on, let me set the expectation right. This post is not about ground-breaking investment strategies or the next big investment idea that you haven’t heard of before. This post is about four simple thoughts that I think would help you in building a strong foundation for your subsequent investing journey. You might have already known about them, but I find them so important and easily overlooked that it’s worthwhile to discuss about them here.
Thought #1 — Don’t rush. The power of compounding, coupled with a simple investing strategy can get you far enough
Investing to grow your wealth needs not be difficult and complicated.
I am not saying that it’s easy. I am saying that it needs not be difficult and complicated. It can be as simple as coming up with a simple investing strategy that matches your risk-reward profile and then leveraging on the power of compounding to grow your wealth.
To fully understand my point, we have to first understand the concept of compounding. It’s a very simple concept.
Let’s say you invest $1 today and the annual interest is 10%. One year later, you have $1.10. Two years later, you have $1.21 instead of $1.20, as the interest that you earn in the first year will give you interest too. It’s as simple as that.
I’m sure most of you have heard of the power of compounding. If not, let me repeat the words of one of the smartest person in history.
“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.” — Albert Einstein
So exactly how powerful compounding is in helping us to grow our wealth?
Let’s do some (simple) math now. Meet Bob:
- Bob has just graduated from university and is working as an engineer;
- Bob earns a monthly income of $3,000;
- Bob spends $2,000 every month, so he saves $1,000 every month, i.e. a savings rate of 33%;
- Bob invests his savings annually, i.e. he invests $12,000 every year; and
- Bob is able to predict the future. He knows that he would get an annual return of 6% on his investment amount every year.
Now let’s make a guess. After 30 years, i.e. after having put in a total of $360,000, how much would Bob have in total, assuming he reinvests all the returns/interests that he gets every year?
[Make your guess now before you read on…]
The answer is slightly over $1 million! Almost triple the amount that he puts in.
At this point, I have a question for you. Do you think you can be like Bob, saving a fixed amount of $1,000 every month and investing the savings annually, for the next 30 years?
If your think you can, good news for you. Assuming that you are 25 (my age) this year, you would have your first million by the age of 55. And note that I am assuming a reasonable and realistic 6% annual return and a constant saving of $1,000 only (remember that you income will go up as you grow older and progress in your career). (At this point, I would highly recommend you to quickly pull up your Microsoft Excel, plug in your own numbers based on your circumstances, and work out the results for yourself. This is crucial if you really want to understand where the power of compounding can bring you based on how much you can/are willing to put in.)
See the power of compounding? The power of compounding can create millionaires from average people.
And see what I mean by investing needs not be difficult? It can be as simple as using the power of compounding, coupled with a simple investing strategy that can provide you an average annual return of 6%. The development of a strategy that gives you the annual return that you want may not be easy, but once you are done with that, what you need to do next is just to sit back and watch the power of compounding works its magic.
You might be thinking, if it’s that easy, why isn’t everyone practising this and becoming rich?
That’s because even though sitting back and letting the power of compounding works its magic is simple, it is not easy. It is not easy because it takes time, patience and a strong belief that it works.
Compounding doesn’t happen overnight. It takes time. And when I say time, I mean a few years, a few decades, which is in fact a very long time.
And during this long period of time, it’s not easy to keep your eyes set on the long-term results and stick to your initial plan, of using a simple investing strategy and the power of compounding, because it seems too simple and you can’t see the results yet.
There are all sorts of things that can make you divert from your plan. For example, the results in the first few years would not be impressive and you might be thinking: “Is 6% annual return really enough to get me to where I want to be financially? My friends have been discussing about an investment opportunity that gives 50% return in 2 years. Maybe I should ask them about that and consider changing my plan. Anyway, the results that I have have been so so only thus far…”
All sorts of thoughts and doubts start popping up in your mind, even though in the first place, no one says you would be see impressive results in the first few years. There is nothing wrong with your initial plan. Your initial plan says that you would achieve your first million in 30-years-time based on an annual return of 6%, not in a few years! What has changed is your own expectations.
This is why I say using a simple investing strategy and the power of compounding to grow your wealth can be simple, but not easy. You have to have the belief (and I mean strong belief) that it would work and strong control over your emotion so as to hinder the short-term noises and distractions (for e.g. get-rich-fast schemes or the next-big investment opportunity that everyone is talking about) from taking you off your original plan.
You have to understand that as long as your investing strategy is giving you the annual return that you have put in in your spreadsheet when you formulated that strategy, even though that annual return rate suddenly “appears” low now, especially when your peers are talking about a much higher return (even though they might not have achieved them consistently for many years), you are fine. You just have to stick to your strategy and allow time for compounding to take you there.
“Successful investing takes time, discipline and patience. No matter how great the talent or effort, some things just take time: You can’t produce a baby in one month by getting nine women pregnant.” — Warren Buffett
Even Warren Buffett, one of the most successful investor and richest man in the world, says that “successful investing takes time, discipline and patience… some things just take time”.
So I would suggest that, finding a simple investing strategy that matches your risk-reward profile and provides you with a good-enough return based on your investment goals, and sticking to it over time for compounding to take its effect, may be a better way to go, as compared to going after more complicated investing strategies or ideas that promise much higher returns.
If you have totally no clue as to what returns to expect, here are some numbers. From 1965 to 2015 (50 years), Warren Buffett’s Berkshire Hathaway had achieved an average annual return of 21.6%, while the average annual return for the Standard & Poor’s 500-stock index (a proxy for the US market), with dividends included, was 9.9%. If you think you can do better than Warren Buffett or the market (most people, including professional investors and mutual/hedge funds worldwide don’t outperform the market consistently), then go for double-digit returns. If not, then I would highly recommend you to manage your expectations and aim for more reasonable returns.
Remember: Don’t rush. The power of compounding, coupled with a simple investing strategy can get you far enough.
“It is not necessary to do extraordinary things to get extraordinary results.” — Warren Buffett
Thought #2 — “Time” is a very important asset of yours. Use it to your advantage
If you are in your 20s, congratulations! You have one very important asset that many other people don’t (and are dreaming for).
That asset is called “time”. Because when you have time, you can afford to structure your investing strategies based on very long time horizons.
Let’s say you are 25 years old now. Take away the large cash-flow hit upon marriage and purchase of your first house and car, and assuming you are going to have active sources of income (e.g. working), most of your savings can be invested for very long time horizons, as most likely you won’t need them until retirement (provided you plan your cash flows properly and have insurance in place to cover for the unexpected happenings).
By very long time horizons, I mean 10 years, 20 year, 30 years, or even more. And this is a very strong advantage if you are investing for the long term (i.e. you are going for value investing or growth investing, and not technical trading).
Why so? Because most asset classes (for example equities) tend to go up in the long run. I am not saying that it definitely goes up in the long run, but the chances are higher if your time frame is longer.
Let’s take a look at the chart for S&P 500 index over the past 35 years since 1980.
No matter which point you take in this chart (excluding those in the last few years as they are not considered “long-term”), the capital value (i.e. the share price) of S&P 500 has increased (note that this is excluding the dividends that have been paid out).
Even if you had invested in the S&P 500 during the peaks in 1999 before the dot com bubble or in 2007 before the global financial crisis, you would still come out fine today, after 17 years and 9 years respectively. You might not get the best returns, but you would come out fine. The same pattern can be seen in other major well-diversified world indices. (Note: The long-term upward trend applies to most asset classes in totality, and not necessarily so for individual assets. Further, “long-term” can be very very long. For example, as of today (26 January 2016), the value of Nikkei index, which is a proxy for the Japanese market, is still less than half of its peak in December 1989, so “long-term” can be very long, even much longer than 26 years.)
As a common investor saying goes, “time in the market is more important than timing the market”. That’s why “time” is a really great asset of yours that you can (and should) utilise, even though its greatness is often overlooked by the people in the 20s (and can only be dreamed of by the very experienced investors in their 50s or 60s who have all the skills and knowledge, but not so much the time anymore).
When you have time, you can afford not to exit the market and hold your investments through the economic crises and cycles that are inevitable parts of economy because you are not out of time and don’t need the liquidity. (Note: I am not advocating that you should hold on to your investments blindly throughout the downturns. For example, if you are into equities, you should always check that the fundamentals and balance sheets of the companies are still strong and solid and can tide them through the down periods.)
Remember: Time is a very important asset of yours. Use it to your advantage!
“In the short run, the market is a voting machine, but in the long run it is a weighing machine.” — Benjamin Graham
Thought #3 — Increasing your savings matters much more than anything else now in your early or mid 20s
If you are in your early or mid 20s now, I assume that you do not have a large sum of money that can be invested in the market. By large, I mean an amount of at least $50,000.
If that’s the case for you, let me tell you this. Within the context of personal finance, savings matter much more than anything else to you now!
What matters now is not about finding the best investment strategy or opportunity that gives you the best percentage return. What matters now is finding ways to increase your monthly savings! Be it from cutting down your expenses (e.g. foregoing that cup of $5 latte everyday or reducing the number of beers that you have during Friday and weekend nights) or from increasing your income (e.g. by taking up freelance or part-time jobs).
The reason is straightforward, although many don’t realise it.
If you have an investable capital of less than $50,000, and assuming you can achieve an annual return of 6% from your investment, the returns from your investment would be a maximum of $3,000 for the year, translating into a maximum of $250 per month. A maximum of $250 per month! That’s what you can get from your investment return. I believe there are many ways that you can increase your savings by $250 per month, the most obvious being cutting down on your unnecessary expenses.
The point is, as strong as the power of compounding can be, if your capital is not significant, the amount that can be compounded on is not large, and thus the effect of the compounding or returns would not be significant, when compared to other sources of wealth generation.
As we have talked about in point #1, the effect of compounding only becomes prominent in the long run, not in the short run. Putting it in other words, a snowball rolling down the mountain only achieves a powerful momentum (that can cause an avalanche) when it has become big enough. At the very start, the speed at which the small snowball rolls down and gathers more snow along its way is rather slow.
So, instead of figuring out the best way or angle to roll the snowball down so that it gathers more snow naturally (read: finding the best investment opportunities that can get you an extra 2%, 4% or whatever % you are dreaming for), you are better off spending your time and effort gathering more snow and building up the size of the snowball yourself the old-fashioned and labourious way (read: managing your personal finance, cutting down expenses or taking up more work to increase your income).
To give you an idea of the difference in results between the two, in numbers term, let’s revisit our old friend Bob (with the same numbers as above) and a new friend, Tom:
- Bob is 25 years old and has $12,000 now. He invests that amount, and then saves and invests $12,000 in every subsequent years, with annual returns of 6%. When he turns 55 (30 years later), he has slightly more than $1 million; versus
- Tom is 25 years old too, but due to his careful spending and part-time work in his past few years, he has already accumulated a capital of $62,000 now (i.e. $50,000 more than Bob). He invest that amount and decides that since he had been working very hard in the past few years, maybe it’s time for him to start enjoying his fruits of labour. He starts working less and spending more, so he saves and invests $8,400 in every subsequent years (i.e. $3,600 less than Bob per year, or $300 less per month), with annual returns of 6%. When he turns 55 (30 years later), besides having slightly more than $1 million, he has slightly more than Bob too.
See the difference? Tom has a head start of an additional $50,000, which he accumulated from his hard work and thrifty lifestyle. But he then spends more than Bob in the later years, saving $300 less than Bob every month for the next 29 years. Even though the total capital that Tom put in ($305,600) is about $54,000 less than Bob ($360,000), in the end, Tom ends up in a slightly better position than Bob.
So the point is that, having a large capital (a snowball of a decent size) as early as possible is of utmost importance. If your capital now is not significant, chasing after the “best” investment product or opportunity may not be the most effective way to increase your wealth and the thing that you want to put your most priority on now. You have a more important priority — to increase your savings, either by controlling/reducing your expenses and/or working on additional active sources of income.
Remember: Increasing your savings matters much more than anything else now in your early or mid 20s.
“When he was 23, Eric Haban, a Boglehead and regular contributor to the forum, expressed the idea beautifully when he wrote: “What most young people don’t understand is that SAVING is more important in the beginning than finding the best performing investment. Having the ability to ‘pay yourself first,’ manage your debt load, and determine a vision of what you want to accomplish is vital to your success. I read an article last week that stated 40 percent of Americans don’t know where their earnings go. The simplicity of saving, coupled with the power of compound interest, is something to be very happy about.”” — Extracts from “The Bogleheads’ Guide to Investing”
Now that you (1) understand the power of compounding, (2) learn that time is one of your greatest assets, and (3) learn that savings matter much more than anything else, what’s left?
Remember the simple investing strategy that can provide you with an annual return of 6%, which you can couple with the power of compounding to get you far enough?
If you are expecting me to give you the answer, I am sorry I am going to disappoint you. But what I am going to share with you in my next point is, in my opinion, even more valuable and important than the answer!
Thought #4 — For long-term success in investing, you can’t just chase after the “best” fishes, without learning how to fish properly
That’s the hard but sad truth of life. There is just no free breakfast in this world, or at least not enough for everyone.
Regardless of whether you have the intention to become a professional investor or not, as long as you want to be in this game for the long term, you have to learn the trade. And I say this for good reason.
Think about this. If you chase after the best fishes, without learning the proper way of fishing, how many fishes do you think you can catch? You might get a few good catches now and then if you are lucky, but how sustainable can this be? Remember, if you are investing for retirement, you have many more years to go, in fact, many decades.
Some of you may be thinking now: “I am not so silly to bet my savings on luck. I have a better idea. I don’t need to understand the trade. I just need to follow my “expert” friends or financial advisers — fish where they fish, fish what the fish, and fish when they fish.”
That might work, provided if (1) you can find such people (they are usually highly mobile, elusive and most probably in a different social circle from yours) and (2) you have access to them all the time (they are usually on the go).
The second point is very important. Because if you fish where they fish, fish what they fish and fish when they fish, without knowing exactly how and why they are fishing what they are fishing, and do not have access to them all the time, when the difficult time comes, there is a high chance that you don’t know what to do.
Imagine if you encounter a difficult fish or a seemingly submissive fish that suddenly goes crazy (read: company having financial problems or bad news), or if the sea suddenly becomes shaky with strong waves (read: economic downturn or recession or even depression), do you think you would know what to do? Should you hold on? Should you let out more line? Or should you even let go before your line breaks?
You can try to copy what your expert friends do (or imagine what they would do if you do not have access to them), but what they do might not work for you, because both of you might have different skills and situations to begin with. They might have used fiberglass fishing rods with higher tensile strength lines, or they know that they have the skill and endurance to fight against the monstrous fish, that’s why they choose to fish on. If you are not aware of those and copy them in fishing on, good luck battling the monstrous fish using a bamboo fishing rod with little skill.
So enough of the fishing (I personally have fished only once before using a simple bamboo rod in a small village, so I hope no one mistakes me as an “expert” fisher). My point is, it is difficult, if not impossible, to achieve success in investing over the long term, if you don’t make the effort to learn about investing so that you have full understanding of what you are doing or are planning to do.
When I say learn about investing, I am not talking about complicated stuff like financial modelling, derivative trading, hedging strategies, etc. I am talking about simple concepts like:
- What is the time value of money?
- What type of investing strategies are there (e.g. technical trading, forex trading, value investing, growth investing, contrarian investing)?
- What asset classes are there (e.g. equities, bonds, real estate, commodities)?
- What are the pros and cons of each asset class? What type of risk-reward does each offer?
- What are the investment products within each asset class (e.g. for equities, they include individual company’s shares, exchange traded funds, index funds and mutual funds)?
- What is portfolio management and how does diversification work (note: putting your eggs in many baskets doesn’t necessary mean diversification if the baskets are quite similar)?
The reason why it is a must for you to understand these concepts to begin with is so that you know what are the options that are available to you in the market and what are their pros and cons, so that you can make active and informed decisions on the type of assets/products that you want to invest in.
You need to have a strong foundation and understanding of the things that you choose, or choose not, to invest in, because without a strong foundation, you would be easily swayed by external happenings and noises as you go (if you are an engineer you know best).
The good news is that these are not as difficult or intimidating as they may seem. They are simple concepts and once you get them, they will stick with you for life.
Maybe in the end, after going through all the trouble to read up on various asset classes and investment products, you might decide to go with a simple strategy of just investing in exchange traded funds (ETFs) coupled with dollar-cost-averaging strategy, which your friend has told you about it long ago (if you don’t know what are ETFs, what are the pros and cons of ETFs and the things to take note of if you want to invest in ETFs, start Google-ing “ETF” now. It’s part of the process of learning about investing!).
However, this time round, your decision (to invest in ETFs) is an active and informed decision. You know exactly why you are going for them, and why not the other options. You know exactly how they work, their pros and cons, and the reasons why they suit you at this stage.
And when you really know about the stuff, and not “know” about the stuff because you hear from people, that’s a very different (and much better) position to be in, for now you would be more well-equipped to tackle all the monstrous fishes that would appear out of nowhere in your investing journey ahead.
As the famed former Fidelity Magellan chief Peter Lynch says, “know what you own, and know why you own it.”
So if you want long-term success in investing, start taking action to learn about investing now. Make that Google search (there are plenty of good articles on the basics of investing, although you have to read them critically). Pick up that investment book in the bookstore or library. And the next time you meet people who know more about investing, instead of asking them WHAT to invest in, ask them HOW to invest and WHY they invest in what they invest.
Remember: For long-term success in investing, you can’t just chase after the “best” fishes, without learning how to fish properly.
“An investment in knowledge pays the best interest.” — Benjamin Franklin
To re-cap, here are the 4 thoughts on personal finance and investing that I think everyone should know in their 20s:
- Don’t rush. The power of compounding, coupled with a simple investing strategy can get you far enough.
- “Time” is a very important asset of yours. Use it to your advantage.
- Increasing your savings matters much more than anything else now in your early or mid 20s.
- For long-term success in investing, you can’t just chase after the “best” fishes, without learning how to fish properly.
Lastly, I would say, if you really want to grow your wealth, focus on saving and building up the size of your snowball now. And in the mean time, take action to learn more about investing, so that by the time your snowball becomes big enough, you already know the best way and best angle to roll (or even, if you like, toss) it down! Happy learning and investing!
If you find this article useful, do “like” it on this Medium page, and share it with your friends so that they can benefit too! Remember: Knowledge, like happiness, is multiplied when shared :)
And if you need tips on how to follow through your resolutions (for example, on learning about investing), do check out my article on “New Year” resolutions!