This past week I had the privilege of setting up a Roth IRA for the daughter of a client. She is 19 and has her whole life ahead of her. What a great time to explain the basic principles of investing. The trick was how to do it. Concepts such as retirement couldn’t be more foreign to one so young. Math can be pretty boring. Portfolio Theory would be the crowning touch to induce sleep or, worse yet, disdain for all things financial.
I decided to show her the value of compound interest. I knew I had to have some sort of interactive tool since most people are visual learners. I decided to use this calculator. We had a brief discussion of what interest was and how important it was to earn interest on your interest. This obscure concept is tricky for young adults, and many older ones too.
We went to the calculator and decided on a monthly savings number. I came up with $120, which is the cost of a dinner for a family of four at a nice restaurant. We put in her age and used an average annual return of 8%. I told her this is a decent guess at an average market return over several decades. I also mentioned that the market rarely returns this number. Often the actual returns can fall anywhere between negative 50% and a positive of the same degree and that there are no guarantees! Back to this later.
We plugged in her age (19) and calculated her balance based on her saving $120 a month until she reached 65. The calculator did its thing and created a fairly flat line until about age 42. Then, the compounding kicked in. A visual showed a hypothetical amount of $691,554 by age 65! It also displayed a bar graph showing a comparison between the amount of interest earned and principal contributed. A quick glance displayed about a 10:1 ratio.
Her eyes really lit up when I told her this number had the potential to be much, much larger if she increased her monthly contribution by $100 each year starting at 21, when she got her first full-time job. I then showed her the cost of delaying saving until she was much older. A $600 monthly contribution starting at age 40 would lead to a hypothetical total account value of just $574, 420 by age 65. Despite the fact that the “late start” contributions were six times greater than the total contributions, there was no catching-up. The account would be worth $100,000 less. That is the price of delaying.
The visuals drove this point home very clearly (try it for yourself). I then brought out my whiteboard and showed her the nice neat straight line fiction that would represent an alternate reality of yearly 8% returns. I erased this and scribbled a very jagged upward sloping graph that got to the same place but with many more ups and downs. Clearly this illustrates that past performance is no indication of future results.
I then circled the downs and told her what you do here will determine if you build wealth or not.
She asked, “Does that mean I shouldn’t sell when the market goes down?”
I said “Yes. Your behavior will determine success or failure. The biggest potential enemy to the plan is you.”
Though the graph was a little scary, she was excited and said she wanted to do this.
That is what I was hoping for. Knowledge without application is useless. My business has access to a robo advisor which is designed for simplicity is perfect for young investors. The sign-up process took a few minutes and we linked her bank account. We then downloaded an app for her I-Phone, which is very user friendly and even gives an option to make one-time contributions if she unexpectedly comes into some extra cash.
Now came the question I was waiting for: “What are we going to invest in?”
We had a discussion about stocks and bonds. I told her since she was young owning more stocks was actually less risky than owning bonds. Over long periods of time stocks generate about twice as much returns. When she asked why, I explained that the zigs and zags of the graph I drew were the price she had to pay for the higher returns. She said she was willing to pay this price.
I told her since her emotions would be the plans greatest enemy, we were going to automate the process. The robo advisor came up with a 90% stock and 10% bond portfolio based on her age. When she asked what stocks she should buy, I told her all of them.
I explained how putting all of your money into a few stocks could lead to disastrous results if just one company went bankrupt. She wondered how much money she would get back in the event of a bankruptcy. I let her know that there would nothing coming back her way and that bondholders would get something back. Instantly she understood why stocks return more than bonds.
I showed her the portfolio. I explained the term “index fund” as owning all the stocks that make up the market of that particular index. So a total market index would own large and small, domestic and foreign — all of them. The advantage to owning this many stocks is that even if a few stocks go to zero, it may not affect the overall return; the risk of owning individual companies is much greater. Buying indices is owning economies, not individual companies. Economies grow over time and that is why stocks go up in the long term.
She asked, “What if the economies don’t grow?”
I told her “If the world economy doesn’t grow over the next 45 years, you will have a lot bigger problems than losses in your Roth IRA.” She thought that was funny.
We set up the account and I told her she would pay 0.25% each year as the price of doing business. I told her that many people pay over 2% in total and her portfolio would likely have better returns because it costs so much less. Another valuable point was hammered home.
We set the account to rebalance after every 10% move or so. “This means you will automatically buy more when the market goes down and sell some things when the market goes up a lot.” She liked this concept.
She was somewhat disgusted these basic money concepts were never taught to her in the fancy private high school she graduated from, and the even more expensive university she now attends.
Imagine if this lesson was required for all kids graduating both high school and college? The tools today are made for a generation brought up on technology. With a few clicks, they can create and understand a portfolio that only large institutions had access to a couple of decades ago, and at a fraction of the cost. The future of our children could be altered, and programs like Social Security and Medicare would be given a funded rebirth.
Like successful investing, the only thing stopping this from happening is us. Our school system; conflicted financial services companies; lobbyists, and incompetent and corrupt politicians are what is standing in the way. Most of all, too many parents are setting bad examples with their focus on materialism and debt, instead of wealth creation and self-sufficiency.
The good news is the tools are there but the right messengers are desperately needed. I did my part. Even though there is a chance she might liquidate this account for tickets to a Fall Out Boy concert or something ridiculous; I have faith in our youth.
What a great time for young people to be alive. The medicine has arrived. We just need some good people to help dispense it.