When transitioning from the life of a carefree college co-ed to a settled-down, full-time employee, presumably you start thinking about saving and investing money for future goals. Investment advice for this group should not be separate from savings advice. A successful investment program depends as much on the amount saved as on the method it is invested.
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Generally, there are two common strategies for saving. The first is to pay one’s bills each month and save what is left, and the second is to decide how much to save each month and then set one’s standard of living to accommodate how much is left. People who take the second approach tend to be more successful in accumulating wealth than people who take the first approach.
Once a savings amount is identified, the next step is to select where to save. The first choice is always in a pension program, which the employer provides a matching contribution. If the amount the individual wants to save exceeds the pension contribution that is matched by an employer, then the next best way to save is through a qualified plan. In most cases, this would be a Roth IRA. This choice is particularly optimal for people in lower tax brackets (e.g., a marginal tax bracket less than 25%). For people in higher tax brackets, qualified accounts wherein the contribution is tax deductible work well. However, there is much to be said for investing through non-qualified accounts, which is the normal account opened at a brokerage firm.
In the pension program and with qualified accounts, a young investor should consider mutual funds. The best are broad based such as index funds. Young investors should also consider only no-load, equity funds with low management fees and no 12b-1 fees. Multiple funds with minimal overlapping of portfolio holdings are a good choice. The selections should be all equity because we know, at least historically, nothing else performs consistently over long time periods as diversified portfolios of common stock.
In the non-qualified accounts, a young investor should focus, again, on equities, but this time the best choice is the direct purchase of individual stocks. This is best accomplished by buying a new stock each time sufficient cash is accumulated. When starting this investment program, don’t worry initially about diversification. Each holding may be only 50 or 100 shares, but over time, it will build into a well-diversified equity portfolio. A good goal might be to own stock in at least 100 different companies. The diversified portfolio will serve as a source of liquidity, either via the sale of holdings, or through the use of margin loans. It will also likely provide tax savings through the favorable tax treatment on qualified dividends and any long-term capital gains that are taken, as well as allow the investor tax benefits on the capital losses that would occur for those investments that do not work out.
Walt Woerheide, PhD, ChFC ®, CFP ®, is Vice President of Academic Affairs and Dean at the American College, a non-profit educational institution with the highest level of academic accreditation for financial services professionals.