You’re a twentysomething, just out of school or a few years into working life. It’s time to start some serious investing.
That’s because time is the investor’s best friend, and you have plenty of it — perhaps two decades to save for a child’s college costs, and probably four decades to build a nest egg for retirement.
I know — retirement seems eons away. And thinking about it makes you feel so settled and middle-aged.
But look at it this way: If you invest a little each month starting now, you won’t have to invest as much as you would if you were to wait another 10 or 20 years to get going.
Imagine, for example, that you want to have $1 million by the time you retire in 40 years. That would be enough to provide an annual retirement income of $40,000 for the rest of your life.
But in fact, you’ll need $3.26 million, because if inflation averages 3 percent a year, that's how much it will take to buy what $1 million buys today. The $3.26 million should produce an annual income of $130,000 — equal to $40,000 in 2007.
Start investing now and earn an average annual return of 10 percent — ambitious, but possible — and you’d have to invest about $7,400 a year to get to $3.26 million in 40 years. But if you wait 10 years to start investing you’ll have to set aside nearly $20,000 a year.
Start early with whatever you can afford. It will make life much easier later.
So what are the key things to know as you launch a long-term investing plan? Here are five tips:
Stocks, stocks, stocks
Stocks are riskier than bonds or bank savings, so in any given year you could lose money. But overall, the stock market doesn’t often lose money over periods longer than five years, because there are fewer losing years than winning ones.
Over long periods, returns in the stock market have averaged about 10 percent a year, while bonds earn a little over 5 percent. Cash, such as bank accounts or money market funds, averages about 3 percent
Look at mutual funds
Though the stock market offers good returns over time, many individual stocks lose money and never recover.
You would need at least 20 or 30 different stocks to safely “diversify” your money — spread it around to reduce risk. To find them you might have to read prospectuses, annual reports and news accounts on 200 or 300 stocks. Even if you know enough to do this — and most individual investors don’t — it’s an enormous amount of work.
Fortunately, we have mutual funds, which are investment pools run by professionals. Even if you have just a few thousand dollars to invest, with a single fund you can spread your money among dozens of stocks, sometimes hundreds. For a small fee, the fund manager does all the hard stock picking. One of the best place to research mutual funds is at Morningstar. Other financial Web sites like Yahoo Finance and Microsoft's MSN Money offer tools to evaluate mutual funds. (MSNBC.com is a Microsoft-NBC Universal joint venture.)
Focus on fees
The average stock-owning mutual fund charges investors annual fees equal to about 1.3 percent of assets — $1.30 for every $100 in your account. That little bit adds up. If your fund held stocks that returned 10 percent, the fee would cut your fund’s return to 8.7 percent. Instead of making $10 for every $100 invested, you’d make $8.70. You’d take a 13 percent pay cut.
Suppose you invested $1,000 today in a fund that earned 8.7 percent once fees were figured in. You’d end up with about $28,000 after 40 years. Now suppose you can find a fund owning the same stocks but charging only 0.2 percent. Your $1,000 will grow to about $43,000.
It’s an enormous difference. That’s why millions of investors turn to index-weighted funds that charge 0.2 percent or less. Instead of trying to find hot stocks, they simply buy and hold the stocks in a broad market index. The most popular track the Standard & Poor’s 500, which invests in the 500 largest U.S. companies, but there are many others.
Many studies have shown that index funds actually beat most “managed” funds over time, because most fund managers can’t successfully pick enough winners to overcome the damage from their high fees. Index funds also tend to produce lower annual tax bills. And because their investing strategy is essentially automated, you don’t have to worry that your fund manager will quit or retire.
Since taxes chew away at returns the same way fees do, savvy investors use a variety of tax strategies.
The best options are the 401(k) or similar retirement plans offered by millions of employers. Your contributions are subtracted from your taxable income. In other words, if you put in $1,000 you’ll save $150 in federal income tax up front, assuming a 15 percent tax bracket.
Also, there’s no annual tax on investment profits, meaning money that otherwise would be used to pay taxes can instead keep growing as an investment. Taxes are paid when money is withdrawn in retirement.
Stick with it
Investing in stocks is a long-term strategy, not something you do with next month’s rent money. If you can weather the downturns you should be pleased with the results.
But remember, when you hear that stocks have returned an average of 10 percent a year, it refers to investments that were left alone, with all dividends and other earnings reinvested. If you make 15 or 20 percent one year, leave it all in the account to continue growing. Don’t take out the “extra” earnings to spend, because they’re needed to offset the years when you make less than 10 percent.