While savings for short-term goals should be in cash, a mix of stocks and bonds are essential to growing your wealth to fund long-term goals like retirement or a child’s college tuition. If your portfolio lacks sufficient exposure to riskier assets like stocks, then you may not generate enough returns to meet your long-term goals. A portfolio that doesn’t take enough risk will also require an unrealistic savings rate relative to your cash flow. Asset allocation is an investment strategy that balances these risks and rewards by allocating a portfolio’s assets to a max of stocks, bonds, cash, and other assets according to your goals and risk tolerance. You can read more about this type of investment strategy and how it fits into your goals here.
2. Max Out Your Retirement Accounts
There are a variety of retirement accounts that offer tax-free compounding of earnings, income, and capital gains. The best place to start is investing enough in your employer-sponsored retirement plan to earn a match. For example, if your employer has a 3% match and your salary is $100,000, you’ll need to contribute at least $3,000 to your retirement plan to be entitled to your employer’s full matching contribution. Failure to make this contribution is like leaving free money on the table.
Once you invest enough in your employer plan to receive the match, then work towards maximizing your contributions to other tax-advantaged accounts in this order: Roth IRA or deductible traditional IRA, employer retirement plan, traditional nondeductible IRA and a taxable account. Both Roth and traditional IRAs allow your money to grow tax-free, with a difference in timing. Some high-income earners can’t qualify for a Roth or traditional IRA. If that’s the case for you, you can move down the list to a nondeductible IRA which allows for tax-deferred growth.
Lastly, although it’s not always thought of as a retirement account, utilizing a health savings account (HSA) can also provide a unique way to boost your retirement savings. An HSA is a special kind of savings account that can be used to pay for medical expenses and other qualifying health-related costs. If you have enough cash flow to contribute the maximum allowable amount to your HSA while paying for medical bills out of pocket, you can potentially compound your HSA for real investment growth.
3. Put Aside Money for A Rainy Day
Having money available for unexpected expenses, regardless of your financial position, is extremely important. In fact, allocating some portion of your excess savings to an emergency fund takes priority over extra debt repayments or additional investing.
In general, an emergency fund should contain three to 12 months of expenses. If your emergency fund is starting from zero, then allocate at least 10% of your excess savings each month to this account. If you have a high degree of job security and income predictability, then you can probably build this account up more slowly. Whatever you can give, just get started with that - even if it’s just $50 to start. If you earn enough, set up automatic contributions from your primary checking to your emergency fund after every paycheck.
Consider keeping your emergency fund in an online account to earn a higher interest rate than you would in your primary checking account. As an added bonus, keeping your emergency savings separate from your primary checking reduces the temptation to access those funds for non-emergency purposes.
4. Don’t Try to Beat the Market
Investing is a complex activity, but that doesn’t mean it requires a complex solution. The problem is that most investors get in their own way by unnecessarily meddling in their portfolios.
While it’s natural to want investments that beat the market, most investors taking this route underestimate the competition they face and the opportunity for success. This type of investment strategy can be great when you’re right about the market but terrible if you’re wrong.
There is also an overwhelming amount of research that shows both individuals and professional investors routinely underperform the market, but that doesn’t mean you shouldn’t invest. Instead, it simply suggests passive vs active investing will improve your chances for success. If you’re a passive investor, you’re in it for the long haul, which makes sense if you’re in your 20s. The strategy requires a “buy and hold” or “stay the course” mentality that limits the amount of buying and selling within your portfolio.
5. Make It Automatic
Finances have a way of getting increasingly complicated as you age. Putting your savings, bills and investments on autopilot can simplify things.
For your investments, automating a dollar cost averaging (DCA) plan removes the need for determining the best time to invest by regularly contributing a set amount to your portfolio. For example, you could contribute $1,000 to an investment account on the 15th of the month for a long period of time. This allows you to diversify not only across asset classes, but time. Making equal dollar purchases over time can potentially lower your average purchase prices because you buy fewer shares when prices are high and more shares when prices are low.
While a lower average purchase price isn’t always guaranteed, DCA is still behaviorally advantageous because investing at regular intervals reduces the risk of buying at the worst times and experiencing an immediate loss in value. DCA is also the simplest way to invest paycheck to paycheck. You don’t have to do anything beyond setting up automated monthly contributions to your accounts.
Start making these changes now. The long term investment strategies and good decisions you make early in life will have more time to compound in your favor and set you on the path for financial success.
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