This post is by Doug Warshauer, who blogs at DougWarshauer.com. He recently released a book, If I’m So Smart, Where Did All My Money Go?: Balancing Your Financial Objectives for Lasting Wealth.
If you are in your 20s, you’ve probably heard – more than once – that at your age you should invest primarily in equities. A simple syllogism leads most experts to this conclusion:
Premise 1: People in their 20s have a very long time horizon
Premise 2: Equities outperform fixed income or cash investments over long time horizons
Conclusion: People in their 20s should invest in equities.
The first premise is generally deemed to be obvious.
The second premise, that equities outperform fixed income or cash investments in the long run, has very convincing historical data supporting it. Jeremy Siegel, a Wharton professor who is one of the most prominent researchers of the relative performance of investment assets, cites reserach that shows that for holding periods of 30 years, equities outpeformed bonds and T-Bills 100% of the time between 1871-2006.
Given the two premises, the conclusion seems inescapable.
However, I think that the first assertion, the seemingly obvious statement that “people in their 20s have a very long time horizon” needs to be questioned. Hidden in that statement is an assumption that people in their 20s will not need the money they are saving for a very long time.
The truth for most people is quite different. Only money dedicated for retirement savings has a very long time horizon. Money dedicated toward other goals usually has a much shorter time horizon. Below are a number of significant savings objectives that people in their 20s must consider.
- Building up emergency funds
- Down payments on homes
- Home furnishings and home improvements
- Down payments on cars (ideally, full payment in cash)
Most of these items have relatively short time horizons. If you are in your 20s and saving to buy a home, you probably don’t plan to wait 15 or 20 years to make that home purchase. The same goes for all the other items on the list.
For items you plan to purchase relatively soon, you don’t want to invest your savings in equities. The risk of substantial losses outweighs the potential gains. Here is an example that demonstrates this imbalance:
Suppose you have a goal that requires you to save $10,000. (It could be a home, car, wedding – it doesn’t matter which). You determine that you can afford to save $5,000 per year for the next two years, which is enough for you to reach your goal.
If you simply put your money in the bank and earn zero interest, in 24 months you will be able to make your purchase. If you start investing in equities and earn a 9.5% annual return (roughly the historical average), you will still need 23 months before you can make your purchase. Your upside for investing in equities: one month.
Now, here’s the downside: if you happen to catch a down market, and your equities lose money at a 20% annual clip (lousy, but far from unprecedented), you will need to wait 31 months before you can make your purchase. With so little to gain and much to lose, it makes no sense to invest money dedicated toward short-term goals in equities.
So, if you are in your twenties, how much of your money should be in equities (dedicated toward retirement savings), and how much should be in fixed income or cash (dedicated toward short term goals)? Ideally, you would create a separate “fund” for each savings objective. Planning to buy a house in a few years? Open up a separate savings account fund specifically to hold the savings you’ll use toward your home.
If you use the segregated fund approach, you don’t really need to worry about the overall asset allocation. You do, however, need to decide fairly specifically what your savings goals are. If you don’t feel comfortable pre-determining your savings goals, you will want to think about the overall balance between long term and short term goals.
If you take that approach, be careful not to underestimate the short term goals. At least try to list out all the major expenses you can envision having in the next ten years, estimate what they will cost, and how much in total you must save each year in order to pay for them.
If you don’t dedicate enough of your savings toward short term goals, you may find yourself eventually needing to go into debt to fund them. Adding consumer debt to support long term equity investing is a losing proposition.
If you go through this exercise and find you are allocating more than half your investments to fixed income, don’t be surprised. Unless you have an unusually high income for someone in their twenties, or unless you are unusually frugal, you will probably need to devote most of your savings to short term goals. This doesn’t mean that your long term future is bleak. On the contrary, by prudently preparing for your near term expenditures, you enable yourself to stay out of debt, keeping you on a solid footing for lasting financial success.
Daniel’s note: I really like Doug’s example of why taking that type of risk doesn’t make sense in the short term. Sure, earning 1% in a savings account doesn’t feel good, but it’s a 21% increase over your worst case scenario. If you can deal with the risk, knock yourself out. Otherwise, look for big wins and don’t put it all on the line to save 30 days.