Investing is scary.
And one reason it’s scary is that there’s a lot to know. That can keep people from starting, which is a shame, because one thing people don’t know much about — compounding, and how it works — means investing can be a great way to build wealth.
People don’t always know how to set their investing goals, says certified financial planner Douglas Boneparth, founder and president of Bone Fide Wealth in New York.
“Without a purpose, we will struggle to identify the amount of risk to take when investing and the types of investments to use,” Boneparth said.
Investing for a child’s education in five years’ time is quite different from a retirement that’s 30 years away. “It always has to be based on a timeline,” said Jeanne Fisher, a CFP with Global Retirement Partners in Nashville, Tennessee, and ambassador to the CFP Board.
Missteps can cost you. Say you’re leaving a job where you saved some money in a 401(k). If you are younger than 59½ and withdraw the money, the IRS will want you to pay the income taxes on it right away, and they’ll smack you with a 10% penalty.
But it’s not just a matter of getting a smaller amount. You are also forfeiting decades of growth on that money, which you’ll need in retirement. This early withdrawal calculator shows what you’re really giving up.
Compounding is magic
It makes sense to start investing when you’re young because you have decades away ahead of you, says Mike Loewengart, vice president of investment strategy at E-Trade in Jersey City, New Jersey.
“Compounding is a simple way of saying that interest is building on interest,” Loewengart said. “That long runway is such a powerful advantage.”
Once upon a time, savings accounts gave you compounded interest, but the yield is no longer there since interest rates are so low.
When you invest in equities, “you have to first grasp the concept that these companies are looking to grow their revenues and profits over time,” Loewengart said. Some of the earnings are paid out to shareholders in dividends, and some are reinvested to achieve growth: This growth directly benefits investors.
You’re doing TDFs wrong
There’s an investment created especially for people who throw up their hands and say, “I don’t know anything about risk tolerance, diversification, asset allocation. Do it for me!”
It’s called a target-date fund, and it’s preset for you, like a cake mix. A TDF has the right composition of stocks and bonds to match your age and investing horizon, based on a specific retirement year.
Here are two ways you might mess up your TDF strategy. First, you might try to make it diversified by adding more layers. “People will take two different target-date funds,” said Fisher. “Especially for younger people, the funds five or 10 years apart are very similar.”
Another way of defeating the fund’s purpose: investing in an S&P 500 index fund, for instance, that duplicates what the TDF already holds.
It may come as a surprise, but your 401(k) is not free.
Yes, your employer wants you to save for retirement. But it costs money.
“Fees can include the costs of buying and selling investments, owning investments and whether or not someone is helping you manage your investments,” Boneparth said.
These costs — as much as $467 a year on a balance of $103,700 — can impact returns. The more you pay in fees, the less you’ll have invested and available to compound over time.
Look at context. Target-date funds, for example, are generally more expensive than passively managed index funds. You are paying for a manager to manage an allocation for you. “But in the world of funds, it’s pretty inexpensive,” Fisher said.
Timing the market
Be wary of the false confidence of those who moved to cash when the market was going down. “That’s only half the story,” Fisher said. “People who get out never know when to get back in.”
In fact, Fisher says, the best rebounds take place after crashes.
Was the market downturn in 2008-09 scary? Absolutely. Some people pulled out and patted themselves on the back.
“If they never got back in, they missed the whole upside,” Fisher said.
Vanguard found that investors who stayed the course more than regained what they had lost. A hypothetical $50,000 investment in an S&P 500 index fund would have dipped by half in early 2009 and then rebounded to $84,200 by 2015, the fund company showed.
Staying too conservative
Wanting to be conservative is an unintended risk for investors, says Loewengart.
Shying away from equities means you’ll have less to spend, because your money won’t outpace inflation.
When you are diversified, you reduce the single-company risk that many people feel can hold them back from investing in equities.
vice president of investment strategy at E-Trade
Equities are considered riskier assets than, say, cash or bonds, but they have the potential to appreciate more over time, Loewengart says. Investing is buying ownership in a company that generates cash flow.
“When you are diversified, you reduce the single-company risk that many people feel can hold them back from investing in equities,” Loewengart said.
Missing out on tax diversification
As great as it is not to pay taxes right away, you may not want all of your invested savings to be tax-deferred.
“The biggest omission, is that if you pay the tax and save [for retirement] in a Roth option, not only is the money you save tax-free, all the growth is tax-free,” Fisher said.
If a 35-year-old saves $10,000 a year and retires at 65, that account will be closer to $1 million with compounding, Fisher says. An upfront tax deduction saves paying tax on $300,000 — but when investing through a Roth 401(k), the entire million is tax-free.
People like the tax deduction today, but there could be a much bigger payoff tomorrow.
Disclosure: NBCUniversal and Comcast Ventures are investors in Acorns.