Times are crazy with the coronavirus, a global recession, a presidential election, and surging valuations across multiple asset classes. Young professionals who have only seen their 401(k) balance moving upward prior to 2020 might be frustrated or freaked out with the current situation, but luckily there are established principles to guide them through rocky times toward future success.
Young savers need to consider a savings rate, time horizon, allocation, tax benefits, and volatility, and they should establish rules to ensure good outcomes.
You can only invest what you've already saved
The first and most important step that young investors must take is to actually save. An optimal savings rate is at least 20% of gross income. This can be challenging with entry-level or junior salaries, high rent, and student loans. But it is important to be diligent and develop some automated savings strategies.
There are a couple popular strategies. One is to have contributions made directly to retirement accounts like 401(k)s. Another is to have your direct deposits split up, with one going into a dedicated savings account to ensure that some fraction of earnings never enters a checking account, which is specifically designed to facilitate spending.
Once savings have been set up, it's important to decide where to house them and how much to dedicate toward retirement. It is usually a good idea to have several months' worth of expenses in a liquid, accessible account at a bank or credit union. Once this emergency fund is built, young investors can dig into allocation for longer-term goals. Balance is extremely important at this juncture to avoid things like credit card debt.
401(k)s and other growth accounts
401(k)s have become very popular as pensions fade into obscurity, but it's important to understand the strengths and weaknesses of these vehicles. 401(k) contributions accumulate on a tax-deferred basis, usually are withdrawn when investors are in a lower tax bracket, and often include some employer-matching funds to augment savings. These are all good things.
But it's important to save elsewhere. Qualified retirement funds are functionally locked away until age 59 1/2, so they aren't available in the event that a cash need arises -- for example, to fund a small-business launch. Moreover, 401(k) savings are fully exposed to income tax rates at the time of withdrawal. If your tax rates are much higher in 40 years for some reason, it wouldn't make sense to defer taxes.
Young investors should consider balancing traditional 401(k)s with a Roth IRA -- or Roth 401(k) if it's offered -- or a normal brokerage account. Roth contributions are made after tax, but they allow tax-free growth and withdrawals in retirement. They also typically allow penalty-free withdrawals up to the amount contributed. This provides some liquidity as well as an excellent tax benefit for accounts that appreciate substantially. With a long time horizon and relatively low income relative to later career earnings, young investors are in a unique position to realize the benefits of these vehicles.
Regular brokerage accounts provide no tax advantages, but they are liquid and still offer growth. Using a mixture of these different account types will diversify tax exposure and balance forced savings with accessibility.
Prioritize growth in your retirement accounts
Investment allocation depends on time horizon as well as personal risk tolerance. Retirement accounts for young investors necessarily have very long time horizons, so they should be optimized for growth.
Young investors' retirement accounts should be heavily weighted toward stocks, and they can get exposure to hundreds or even thousands of different equities through mutual funds and ETFs. Diversification ensures that poor performance in any single stock, industry, or part of the world cannot ruin account performance. Growth allocations should also include exposure to more-volatile stock categories with high upside, such as small-cap growth and emerging markets.
Young investors have time to ride out market cycles and the opportunity to ignore temporary downturns while waiting to sell at advantageous times closer to retirement. To achieve growth above the market rate, it might also be beneficial to consider an allocation strategy such as factor investing, which has compelling historical evidence that returns can be augmented by heavier exposure to smaller, profitable companies with attractive valuations.
Young investors need to start with saving in a systematic way, then move on to a balanced, rules-based allocation method across different accounts and asset categories. Retirement savings should be earmarked specifically for growth. While times are turbulent in 2020, it's still a great time to own high-growth assets in a retirement account.