I recently read an interesting article that implied millennials were afraid of investing. The article further stated that 51% of millennials had not held a conversation related to handling their finances with even one person. With the assortment of resources available to educate an individual about investing it’s shocking that over half of the millennial generation may not be taking advantage of these conversations. Most brokers offer free planning conversations. Also banks and credit unions would love to talk to their customers about planning, and increasing their long term assets. Furthermore, just about everyone knows someone who has experience with investing that they could talk to.
The article then detailed another shocking statistic from a 2014 Bankrate.com study stating that 39% of respondents aged 18 to 29 say cash is their preferred way to invest money that they don’t need for at least 10 years. Being one of the major asset categories cash definitely does play a part in one’s portfolio. Cash is great if money is needed in the short run; say within the next two years because you do not have to worry about fluctuations. However, given a 10 year timeframe that money would be better off being invested in other assets besides cash because of inflation risk.
More on Inflation Risk
Inflation is an increase in the cost of goods or services, so a dollar today will not buy the same amount of stuff at some point in the future. The lack of ability to buy the same goods with said dollar is also called a reduction of purchasing power. Economies need a certain amount of inflation in order to grow, so if your cash earns less than the inflationary amount you are in trouble. Currently rates for CDs and Money Market accounts are less than 2%, unless you are locking your money in for longer periods of time. The great thing about investing in stocks is that for the risk you take on you receive a rate that is typically higher than inflation which allows your money to grow over the long run.
Emily Pachuta, head of Investor Insights for UBS Wealth Management, said in a release. "Millennials seem to be permanently scarred by the 2008 financial crisis," and that “they have a Depression-era mindset largely because they experienced market volatility and job security issues very early in their careers, or watched their parents experience them, and it has had a significant impact on their attitudes and behaviors." That change in attitude has led to an increased preference for cash with an average of 52 percent of millennials portfolios being in cash, compared to 23 percent for investors of other generations. Investors who are risk averse think that it’s a smarter bet to be in cash, not realizing that they have already lost money due to the inflation risk which cannot be avoided. In the long term, inflation erodes a portfolio’s purchasing power significantly. At an average inflation rate of 3% per year, the value of a portfolio is cut in half every 23 years or so.
The Cost of Being Out of the Market
Below is a graph that shows just how much money an investor could lose by being out of the market on the best days over a given timeframe.
Take Advantage of Lower Income
Chances are that as a Millennial you have a lower income than you will have as you progress in your career. The great thing about a lower income now is that you will pay less in taxes. Contributions made to a Roth IRA are done so on an after tax basis, meaning it will not lower your income for the year. Also at certain income levels you could be phased out from contributing to a Roth or have to make partial contributions. For most individuals the long term tax saving potential exceeds the cost of not receiving a reduction in income.
Tax Free Contributions
Individuals under 59 ½ can make full contributions up to $5,500 for 2014 to a Roth if their adjusted gross income is below $114,000, the amount for couples would be $181,000. Contributions to Roth IRA’s are always tax free. If you happen to invest the funds, and make a profit you will be taxed on the earnings if you take a distribution and certain conditions are not met. For example, let’s assume you contribute the full $5,500 to the account and the value grows to $7,000. The $5,500 can be taken out of the account tax free; the remaining $1,500 may be subject to taxes and a 10% early withdrawal penalty. In a sense taking a distribution from what you have contributed is like getting a tax free loan.
Potential Tax Free Distributions
At some point the entire value of the account may be tax free. Withdrawals of earnings taken from a Roth IRA after the five-year aging period has been met are tax and penalty free if one of the following conditions is met: 59 ½, disability, death, or qualified first time home purchase.
Compounding of Money
The younger you begin to save the more time your investments have to grow and benefit from compounding. Another benefit to Roth IRAs is that they do not require original account owners to begin taking a minimum required distribution (MRD) at age 70 ½, meaning your money has even more time to grow if not needed. Below is a graph which shows the effects of compounding at different returns.
This hypothetical example is provided for illustrative purposes only and is not meant to represent the return of any specific investment product. Data assumes that each age group is making their maximum eligible contribution to an IRA account at the beginning of each annual period. $5,500 is contributed annually until reaching age 50, then $6,500 is contributed thereafter until age 65. Investment returns and principal value will fluctuate so that investments, when redeemed, may be worth more or less than original investment. Chart taken from etrade website.