Not many college students think about building an investment portfolio. Though students often feel too busy studying for exams or planning their career, initiating your investment journey at a young age can be both manageable and tremendously advantageous in the long run. Before I get into the technical reasons behind the benefits of investing early, I’d like to share a couple lessons I have learned from my recent college experience regarding finances in general.
The first lesson is to get into the habit of saving money regularly. Developing a saving mentality is an essential building block to a financially sound future. While I always considered myself to be somewhat frugal, I found that my savings habits came in inconsistent waves. I’d go a month or two without spending a dime, followed by another period where I spent money like I had just won the lottery. This resulted in me not having the funds to do some of the things I wanted at certain times. Consistently saving not only helps to ensure that you will have something to pull money from if you really need it, but it also develops a mindset which serves as a foundation for smart investing for the long term.
Another key take-away for me was realizing the value, literally, of patience. Years ago, before I fully understood some of the core principles of investing, such as diversification, I thought it would be fun to have my very own stock in a company. Naturally, as a 15-year-old whose life was 90% soccer and basketball, I chose to buy shares in Nike. Thanks to birthday and Christmas gifts of Nike stock from my grandfather in subsequent years, I had built up a considerable amount by 2018. Then, in January of this year, the market experienced severe volatility. Being the nervous, inexperienced investor that I was, I sold all my shares in early February at $64.39. The price of a share today is $79.52. While hindsight is 20/20, had I held it through today I would currently be up roughly 23% from early February. This is a great lesson, as it shows how a lack of patience can cost you.
Enough about me – Why is starting young so important? Ultimately, the reason to invest early has to do with time. When you invest with a longer time horizon, you benefit from the law of averages (also referred to as the law of large numbers), which is the notion that, over time, events that have an element of chance will eventually align with their long-term average. For example, Dimensional Fund Advisors tells us that from 1926 through 2017, the average annual return of the S&P 500 is 11.9%. Most investors would be ecstatic if they had this return on their portfolio each year. However, if you look at any individual year, you would notice that the return almost never falls on that long-term average of 11.9%. This presumes that the shorter amount of time you have to invest, the larger effect an outlier year will have on your portfolio. Let’s look at some scenarios. In the table below, you invest $1,000 a year with a 10% annual return across varying time horizons (we’ll use 10% to be a bit more conservative).
|Time Horizon||Annual Contribution||Annual Return||Cumulative Net Worth||Overall Return|
|10 years||$1,000||10%||$ 17,531.17||75%|
|20 years||$1,000||10%||$ 63,002.50||215%|
|30 years||$1,000||10%||$ 180,943.40||503%|
|40 years||$1,000||10%||$ 486,851.80||1,117%|
If you invested $1,000 a year starting when you were 20 years old, assuming you get just below the average S&P 500 return of 11.9%, by the time you are 60 your portfolio would be worth $486,852. At the end of this 40-year period you would have contributed a total of $40,000 and earned a 1,117% return! As you can see, having a longer time horizon has an exponential effect on potential overall return. Again, you would not actually see an 11.9% return every year (one year the market may be up 20% and another down 20%), but the advantage of investing at a young age is that, over years of smart investing, the outliers will tend to offset leading to a more dependable overall return. This brings me to my next point: stress.
One of the biggest drawbacks to investing is the amount of emotional stress it can put one through. People become obsessed with day-to-day market fluctuation, which can cause unnecessary anxiety. With an extended time horizon, and the law of averages in effect, starting in college should allow one to invest relatively stress free, understanding that any market downturn should eventually be reconciled by future upswings.
With all this to think about, actually starting the investment process seems like a daunting task for the young investor. Let’s dive into the key steps you need to take to get started.
- Determine your initial dollar contribution, how much you want to contribute regularly, and how frequently you want to contribute. A simple suggestion would be to put down $1,000 right away and contribute $100 each month, assuming you have some form of income.
- Choose a brokerage to use. While a traditional brokerage, in which you get one-on-one advice and services, is still an option, an online discount brokerage is the way to go, as they tend to be much cheaper and far more convenient. There are many online discount brokers to choose from. A great option is Vanguard. Some of the benefits of Vanguard include extremely low fees on their funds, as well as a low minimum required investment amount.
- Choose what type of account to open. If you’re just starting, an individual brokerage account (cash account) is the most straightforward and could be the ideal choice, as it allows you to invest and take out cash at will. Some other options are a Traditional IRA or a Roth IRA, but that’s a conversation for another time.
- Do some research and figure out what type of securities to invest in. The key is to diversify, and one of the best ways to do this is to invest in index funds, such as mutual funds, which represent a collection of holdings aimed at tracking certain indices, giving you a diversified look in a single position. One thing to look at when choosing index funds is the expense ratio. This is the annual fee that these funds will charge you for holding their security. Many mutual funds can be found with expense ratios below 0.1%.
Hopefully by now you have a better idea of the advantages associated with starting the investment process at a young age and how to get started. Remember, since you are young, your time horizon is long, and a bad year in the market doesn’t mean you will permanently lose all (or any) of your money. Continue to research and make adjustments you deem necessary, but for the most part just sit back and watch your wealth grow. Now go get it done.
(Dimensional Fund Advisors)