Millennials Save Plenty, But Don't Invest

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Millennials have a high savings rate but buy very few stocks.

This leads to inadequate results for most people's retirements.

Investing implications of a generation that doesn't own stocks.

As Seeking Alpha readers, there's a good chance you know a fair bit about investing. However, it's easy to forget that our portion of the world is a small one; many people know little to nothing about investing.

This is especially true of my generation, which has shown an unusually low amount of interest in the stock market. The common claim is that millennials don't have money, and thus can't invest. However, this is largely false, once you consider that millennials actually have unusually high savings rates. They simply aren't deploying that cash into any higher-return investment vehicles. Here's a sobering table:

As you can see, millennials have fully 70% of their assets in cash, compared to 60% or less for significantly older generations.

The stocks-bonds split is particularly troubling. Generally accepted portfolio theory suggests that investors should own more equities early in the accumulation stage of life, and gradually shift to bonds as retirement nears. Instead, millennials own just $2 of equities per dollar of bonds, compared to more than $3 for Generation X, and $4 for the Baby Boomers. Even the silent generation, already well into retirement, hold a higher ratio of stocks to bonds than millennials.

And it isn't just that millennials don't have good enough jobs to be able to afford to invest. Consider the following:

Despite that low participation in the stock market, Bankrate's previous research has found that Millennials actually save more than previous generations, for both emergencies and retirement.

"Much of this is attributable to the financial crisis and Great Recession coming during the financially formative years for many Millennials," Greg McBride, Bankrate's chief financial analyst, said in a statement in March.

An earlier Bankrate survey found that 62 percent of Millennials will save more than 5 percent of their income this year, an increase from 42 percent in 2015. A third of Millennials are saving more than 10 percent of their income, which is up from 22 percent last year.

These are actually quite impressive numbers. Since the turn of the century, the US savings rate has held around 5%, and at times gone even lower:

Thus, millennials are doing a great job of saving; fully a third are saving 10% of more of their incomes - double the national rate. And yet many are still haunted by the ghosts of the financial crisis, unable to overcome the psychological trauma of that hard period.

Let's consider a hypothetical situation. A millennial has $50,000 in annual income, saves 10% of it annually, and starts with $10,000 in capital. He decides to put it all in cash, which - ignoring recent low returns - can historically be expected to generate about 3.5% base returns. We'll optimistically assume rates return to 3.5% over his investing lifetime.

In 35 years, that $10,000 initial investment + $5,000/year savings adds up to $367,000. That's enough to modestly help one's retirement, but particularly after considering the impact of inflation, it's not nearly enough. One could assume the millennial's income will rise over the years, or perhaps the savings rate can be increased over time. Still, the point is, a 3.5% rate simply isn't high enough to allow much compounding, even with a massive 35-year time horizon. Consider (source):

This model portfolio, even after 35 years, only produced $1 of interest per dollar of capital contributed. That's simply inadequate for meeting retirement needs, even based off a healthy 10% savings rate and starting early in life.

By contrast, a millennial with a lower savings rate but who understands the need to invest in stocks makes out much better. Consider the same millennial with $10k and a $50k income. He saves only 5% of his income, contributing just $2,500 a year. However, he invests in a stock-heavy mix of assets that generates 8% a year returns. Despite having only half the savings rate of the more conservative investor, he ends up with $579,000, a more than $200k improvement.

Despite saving far less money, the investor in stocks ends up with a much more formidable retirement nest egg. That's because the portfolio ends up with mostly interest gains, rather than initial contributions:

It's great news that millennials have figured out they need to save from an early age. A 30-year-old with a modest $2,500/year savings rate can end up with more than half a million in retirement savings with relative ease as long as stocks are the major part of the portfolio.

However, even a 10% savings rate invested in cash at 3.5% or less isn't going to compound to much of anything.

Long-Term Effects Of Millennial Underinvestment

There are a few potential ways this can play out. One possibility is that millennials never get over their fears about stock market investing. This would severely depress US equity prices in the future, once older more equity-heavy generations start trying to sell stocks and find there to be few buyers.

As millennials age and acquire more earning potential, they could sharply alter the demand for capital. By overinvesting in safe assets, such as CDs, government bonds, etc., and underinvesting in the stock market, we'd end up with artificially low interest rates, and higher expected returns for the stock market.

The transition to reach this stage could be rocky, however. We'd likely see the P/E ratio for the S&P 500 (NYSEARCA:SPY) contract sharply, causing sharp losses at a time when many people were counting on their stock portfolios to allow them to retire comfortably. This could cause quite a feedback effect triggering more selling.

Another possibility is that millennials will eventually grow tired of the stock market rising without them, and start to plow money into the market. We've already seen this to some degree, as younger investors start gradually moving money into FANG stocks and other such momentum names. As they have success, they tell their friends to get in too, and excitement spreads. New technology, such as the Robinhood app, makes trading cheaper and more accessible to young investors than ever.

The downside of this would be that millennials would be likely to invest at the wrong time. This in the same way that many people who decided to avoid the stock market after the disastrous 1970s period finally got into stocks again in the mid-to-late 1990s, as stocks only went up and everyone's neighbors were getting rich. We know how that ended.

Assuming millennials stay parked in cash, or they move into the market near a peak and suffer large losses, it brings up an interesting question. What happens to this generation when it wants to retire? As shown above, even a 30-year-old dutifully saving 10% of his income but putting it in CDs won't be anywhere close to having a fully funded retirement. Yes, there are government safety nets to help with this sort of thing, but they appear increasingly strained the farther out you look on the horizon.

As for what we can do, if you're a younger investor, make sure you have a healthy allocation to stocks. And if you are an older investor, encourage the younger people in your life to learn about investing and start buying stocks while there's still time for compounding to make a large impact.

Yes, I know some people will say, but Ian, the stock market is up 3x since 2009. This isn't the time to start investing. However, a similar argument has been made since at least 2012. The market usually looks overvalued. Stocks climb slowly, but crash rapidly.

Thus, by nature, the majority of the time, we're in bull markets. Even if you have the mental fortitude to only invest during bear markets (something most people don't have), you still go many years at a time without having the chance to put more capital to work. I know the market looks expensive now, but putting 70% of your money in CDs, as millennials seem to be doing, is a guaranteed recipe for investing failure.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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