Posted by Cindy Wilson.
When I was younger, life was all about making mistakes and not worrying too much about the consequences. A lifetime of second chances seemed to stretch out before me.
But today when I speak to younger people just starting out with a first portfolio, I tell them it’s because they have time on their side that they need to get their investment strategy right on target as soon as possible; a misstep can have an enormous impact over the long term. Like the Robert Frost poem where “two roads diverged in a yellow wood,” the one you take, small and inconsequential though it may seem at the time, “makes all the difference.”
To illustrate how much of a difference, check out the divergence (in compound annual return) between a $100 equities investment, a $100 Treasury bond investment, and a 50/50 hybrid of the two, over a long historic period.1
The more years that pass, the more an aggressive (stock-oriented) strategy can pay off, provided you buy-and-hold without losing your nerve and selling during a recession or other market dip. Younger people have time to weather market volatility (or the zigzags in the road). For narrower time horizons, it’s a riskier strategy; older investors, verging on retirement, tend to balance their portfolios in favor of bonds.
Bulk-buying toilet paper
Investing in the stock market is a bit like shopping in a supermarket, where an 80-roll pack of toilet paper is $50 one day and inexplicably $30 the next. Thrifty consumers stock up on household supplies when they’re on sale. This technique, when applied to investing, is known as dollar-cost averaging.2
Imagine you’re an office manager with a weekly budget of $100, and instructions to spend that entire amount. When you visit your supplier one week, there’s 50% off everything in store, so you come away with double the amount of toilet paper and office supplies. Similarly, when stock prices are low, you get more shares for your money.
Seeing your 403(b) balance go south can be disheartening, but take heart that your dollar contribution for that pay period is buying you more units of whatever you’re invested in. The key is not to panic and sell out when the price is down.
More forks in the road
If you’ve decided equities are a worthwhile road to venture down, you’re still not out of the woods. There are further forks in the road, further decisions to be made about what companies you want to buy a piece of.
Start by looking at the fund lineup for your employer-sponsored plan. Some plans have 10 to choose from, while others have 50. Log in to your account to access the full list of options. Within the equities asset category, seek diversity: You may decide to hedge your bets among domestic and international stocks (for instance by dedicating 10% of your portfolio to the latter) or among small- and large-cap companies. The $100 equities example above is based on the large-cap S&P 500 (an index of the 500 largest U.S. companies). Larger companies have historically offered more stability, while the performance of small stocks zigzag like crazy (meaning more volatility – but also opportunity). Here are the various possible pathways taken by $1 invested in 1926.3
Should young investors be completely aggressive?
An overall portfolio doesn’t merely consist of retirement savings. And a retirement portfolio doesn’t have to merely consist of aggressive investments–even for younger people, who can afford to take more risks. Tying all your assets to the market is a bad idea when there’s a chance you’ll need some of that money before retirement.
In the above example I used an equities-only portfolio to make a point about how this asset class has traditionally outperformed all others over the long term. A retirement portfolio can be more nuanced, with a diversity of funds and account types: 403(b), traditional IRA, Roth IRA (the latter offers some flexibility around early withdrawals). You may decide to pursue an aggressive path with just a portion of your portfolio, for example by putting your employer match money—since it’s “free money”—into a high-risk small-cap fund. Meanwhile, you may opt for more conservative investments in your Roth IRA, in case you need to tap into it during an emergency.
The reality is that you can suddenly lose your income at any age—through job loss or time out to have kids—and your 403(b) is a last-resort emergency fund. I saw friends get laid off during the last recession, who resorted to cashing out a stock-heavy 403(b), its value battered by the market dip (and further diminished by a 10% early withdrawal penalty). Given life’s vicissitudes, it’s better to have a separate cash account set up.
Bottom line: Robert Frost may have taken “the road less traveled” but to make all the difference, younger portfolio owners embarking on life’s journey might want to consider the well-trodden path of equity investing; and diverge from the false security of “safer” roads, which are traditionally less adequate for outpacing inflation.