Note: This is the first in a series of Lifecycle Planning articles for every age group.
Many experts believe that one of the keys to lifetime financial security is building a solid financial foundation during the early adult years. This makes the 20s a critical time from a financial planning perspective.
For most people, the 20s represent the stage of life when they are establishing their financial independence. During their early 20s, many people are graduating from college and venturing out into the professional workforce perhaps for the first time, while others who have bypassed college are working at their first professional jobs. In either scenario, these individuals are on the first miles of a long journey that they hope will lead to a lifetime of financial security.
Develop Financial Management Disciplines
However, for this to happen, it is critical that these individuals develop sound personal financial management disciplines during this important life stage. Here are four personal financial planning strategies for 20-somethings:
- Set financial priorities. The 20s can be a very exciting time for young adults who are getting their first taste of independence — living on their own, earning their first paycheck, and making their own financial decisions. But with this independence comes the responsibility of setting financial priorities.
This will be easier for a single person with limited responsibility than for someone who gets married and perhaps starts a family early. Nevertheless, for either individual, the first step to setting financial priorities is to establish a budget. Budgeting is a relatively simple process, especially if it is started early in adult life. It helps ensure that the most pressing financial priorities — like paying the rent and utilities and buying insurance and groceries, for example — are covered before money is spent on “extras” like entertainment and fancy clothes.
- Pay down debt — and keep debt low. Once basic financial priorities are covered, it is wise for these individuals to start focusing on paying down any debt they might have accumulated at this point in their lives. For many 20-somethings, this consists of student-loan debt, credit card debt they may have incurred while in college, and possibly a car loan.
Ideally, debt payments should be part of the monthly budget, as amortizing debt like student loans and car payments usually must be repaid according to a fixed schedule. Credit card debt is what can get many people in their 20s in the most long-term financial trouble. Sometimes, 20-somethings fall into the trap of just making the minimum payment on their credit card bills. Doing so can stretch credit card debt out for many years and result in hundreds (or even thousands) of dollars in extra interest expense.
Instead, young adults should put as much money as they possibly can toward paying down their credit card balances — with the goal of paying off credit card debt in full as soon as possible. Then, credit card balances should be paid in full every month to avoid interest charges. Establishing this discipline in the 20s can help avoid a lifetime of debt problems.
- Start saving for retirement. For individuals in their 20s, retirement can seem like it is an eternity away. That’s why it often falls to the bottom of the financial priority list. “There’s plenty of time to save for retirement later, when I’m making more money and getting closer to retirement age,” is how the thinking often goes.
Unfortunately, these individuals sometimes don’t get around to setting up a retirement savings plan until much later, if they establish a plan at all. By this time, they have lost valuable retirement saving years that can never be recouped. An example helps illustrate how those who start saving for retirement in their 20s can benefit from the power of compounding to grow their savings exponentially over the long term:
Let’s say that John opens an IRA at age 22 and contributes to it each pay period. When he’s 25, John has built up a nice little retirement nest egg worth $5,000. Even if he never makes another IRA contribution for the rest of his life, his IRA will be worth $54,787 when he’s 65 (assuming an average return of 6 percent per year, compounded monthly).
But look what happens if John waits until he’s 32 years old to open an IRA. This time, let’s assume it’s worth $5,000 when he turns 35. In the same scenario, his account will be worth just $30,113 when he turns 65. Notice that John saved and invested the same amount of money over the same length of time — but waiting ten years to get started cost him more than $24,000 in compounding returns.
- Maintain a long-term perspective when it comes to investing. This example highlights the tremendous benefits that can be realized by getting an early start on long-term financial goals like retirement. Moreover, individuals in their 20s are in the best position to realize these benefits if they adopt a long-term investing perspective.
This means not getting caught up in the day-to-day, month-to-month or even year-to-year gyrations in the financial markets. When investing with a 40-year (or longer) time horizon, these short-term market fluctuations are mostly irrelevant because young investors have so much time to potentially make up short-term losses. And remember: Short-term investment “losses” are only real losses if the investments are sold.
A better strategy for many 20-something investors is to contribute money to their retirement account on a regular, systematic basis using a strategy that is referred to as dollar-cost averaging. This simply means investing the same amount of money each pay period (or each month) regardless of whether the markets are up or down. When markets are down, more shares will be purchased, and when markets are up, fewer shares will be purchased. This strategy tends to even out share prices over time and thus reduce the impact of market volatility on a retirement portfolio.
In addition, when investing with a long-term perspective, young adults may be able to assume a little more risk in search of higher returns, since they have more time to make up losses in the short term. That’s why many experts recommend that these individuals include a higher allocation of stocks and stock mutual funds in their retirement portfolio than fixed-income instruments (like bonds) and cash equivalents. While riskier in the short term, stocks generally offer the potential for higher returns than bonds and cash over the long term.
Lay a Solid Financial Foundation
If you are in your 20s, don’t miss out on the tremendous opportunity you have to put these financial planning strategies into practice. Doing so now will help you lay a solid financial foundation that will last for the rest of your life.