My daughter will be graduating from college in May. She is 22 years old, has her entire life before her, and is both scared and excited about what she will do after graduation. So what am I going to do in the next two weeks? I'm going to sit her down and talk to her about retirement. Yes, I think it is time for her to start thinking about retirement. I doubt that she has ever given a thought to saving and investing. But it is essential for her financial wellbeing, so it's time we sit down and discuss it.
I don't think most college students have much of an idea about how to manage money effectively. Most have always relied on their parents to take care of them financially. But once they graduate they have to get their own jobs and have to start supporting themselves. Their spending habits have to change, their savings habits have to change, and their lifestyles have to change. This will not be easy for many of them to do because they have never had to worry about money before. And it can be a rude awakening. They have never had to worry about saving before. If they did have any money from a part time job it was usually considered spending money. All the essentials (tuition, rent, food) where paid for by their parents. So saving is an alien concept to them. And investing? Retirement?? Most have never even considered it! At such a young age it's not easy for kids (young adults?) to be thinking about saving for retirement. To them it is so far away it's almost non-existent. To get them to start thinking long term is very difficult. But for their own good they need to learn.
Don't get me wrong, some college students work full time, are financially independent, and pay all their expenses themselves. But for those who have been dependent on their parents, like my daughter, this is meant for them. This is written for my daughter, but for any soon-to-be college graduate, this is for you as well.
Saving - To be ready for retirement you must save for your whole life.
1. Live within your means. This will be the most important lesson for you. You absolutely MUST NOT spend more money then you earn. If you are like many young adults, as soon as you get any money in your hands you spend it. Clothes, movies, nights out with friends….whatever. While in college your parents paid the rent, paid for groceries, paid utilities (especially the cell phone!), and most importantly they paid your tuition. So anything you made in a part time job was, by definition, spending money. But no more. After graduation you must realize that you will be responsible for all of these expenses, and that these essentials must be paid before you can think about buying new clothes, or another iPod, or going out to dinner for your friend's birthday. You will have to learn that all the fun things you are used to buying or paying for will have to take a back seat to paying for all the essential things you needs to live. And that brings is to the second lesson….
2. Delay gratification. There is nothing wrong with wanting to buy something that you want. But with the change in your financial situation you are going to have to learn to put off that purchase. If it is something you really feel is worth having then you should start saving money, and when you have enough saved then you can go out and buy it. But under no circumstances should you put anything on your credit card that is not absolutely necessary. A credit card is for NEEDS, not wants. And that leads us to point number 3……
3. Minimize debt. Getting into debt can lead to trouble. Some debt is good. A mortgage, a car loan, maybe even a business loan. All are responsible uses of debt. And having a credit card and using it responsibly is a great way to establish a good credit score. But piling debt on your credit card just to buy things you really don't need is a recipe for disaster. The late fees and interest charges will add up very quickly, and cost you far more then the original cost of the product you bought. If you can't afford to pay off your credit card at the end of each month, then you are taking on too much credit card debt.
4. Keep your costs low. The best way to live within your means is to keep your costs low. Rent an affordable apartment. Buy a used car. Shop at the discount stores for your clothes, or at the more expensive stores only if the clothes are on sale (look at the clearance rack!). Buy groceries and household goods in bulk, and cook for yourself. Eating out is very expensive. And cut coupons! Save money any way you can. By following these tips you can still get all the things you need while also keeping your expenses as low as possible.
5. Make a budget. This is essential. Every month calculate what your income is and then figure out what all your fixed costs are. Fixed costs include rent, utilities, car payment, student loan payments, etc. These are things that cost the same every month, and that you must pay for month after month. Once you have subtracted these fixed costs from your take home pay what you have left over can be used for your non-fixed costs. Non-fixed costs change month to month, but they are still things that must be paid every month. This would include things like groceries, gas money and clothes. Figure out how much you need to spend on these things and add it to your budget. Make sure you stick to that amount. Finally, after subtracting all these necessary expenses from your take home pay, what you have left over is what can be spent on the unnecessary things. By making a budget before hand, and knowing what you expect to spend on each category, you will have a better chance of not over spending, and of not having to use your credit card.
6. Save receipts. This is a good habit to get into. When you first get out of college and get an entry level job you will most likely fill out the 1040-ez form when calculating your taxes. So you will take the standard deduction. Receipts won't help you. But when you start earning enough to begin itemizing your deductions, saving your receipts will be a big help. Get into the habit early.
Investing - Now that you know how to save here is how to invest for retirement.
A. Get an advisor and Make a plan. You probably don't know much about investing, even if you think you do, so find someone you trust who has a lot of experience, and read a lot of books. Educate yourself. And once you are ready to start, make a plan on exactly how you are going to invest. What will you invest in? How often? How much? What are your long-term goals? Decide all this before you start and set it up in such a way that you can easily follow the progress and determine if you are meeting your goals. As time goes on you can change the plan if it is not working or if your situation changes.
b. Pay yourself first. You're probably going to have a relatively low paying job, and for the first time in your life you will be responsible for all your expenses. So how are you going to have any money to invest? You are going to pay yourself first, that's how. By this I mean you are going to set aside (SAVE!) at least 10% of every paycheck and put it into a bank account. This 10% has to be part of your budget so that it is just as much of a priority as any other of your expenses. Once you have enough saved to cover about 2 months worth of your expenses you can start putting money into a retirement account and begin investing.
C. Open a Roth IRA. Use a discount broker and open a Roth IRA in which to put your investment funds. This will be funded with after tax money, so when you retire and withdraw the funds you will not have to pay any taxes on it. You can check with an accountant to see how much you can put into the Roth. Maximize this as much as possible.
D. Invest regularly. Once your investing account is set up, and you have your investing plan set, you can start investing. Your plan should include regular purchases at a set time period. It's up to you what time period you pick, but monthly purchases would probably cost you too much in commissions. Quarterly or yearly is probably best. Don't skip any investments. Make sure your quarterly or yearly investment is in your budget and execute it.
E. Diversify. You don't want all your eggs in one basket. If you own too much of one type of investment, one stock, one ETF, only owning technology stocks, etc. and it goes against you, your portfolio can take a big loss. When you first start, with the low amount of funds you will have, it's probably best to start with an index ETF. These are naturally diversified, have low fees, and pay a decent dividend. Once you have enough to start buying individual stocks, you can begin building a portfolio of 20-30 stocks, in different sectors, to make sure you maintain diversity.
F. Buy dividend stocks and use the miracle of compounding. There are two reasons to buy stocks. One is for capital appreciation, which means that the stock rises in price and you sell it for more then you bought it. The other reason is to collect dividends, which is cash a company pays you just for owning it's stock. I suggest buying dividend stocks. No one knows what will happen in the future with stock prices. If the stock you own does not go up in price you gain nothing. But with a dividend paying stock you keep collecting cash, quarter after quarter, year after year. Even if the stock price doesn't go up, you still get a return. And don't just buy stocks that pay a dividend. Buy stocks that pay a dividend that rises YEAR AFTER YEAR! And once you have that dividend, reinvest it. This is how compounding will kick in. With compounding, when you reinvest your dividends, now those reinvested dividends will pay even MORE dividends next quarter. This causes your dividend returns to grow exponentially. A stock like Coke (NYSE:KO) has been paying a higher dividend, year after year, for the past 50 years. Every year you get more money. Over a 50 year period, this can lead to great wealth.
For example, lets say you put $1000 into a stock that pays a 3% yield. In the first year you will collect $30. But now lets assume that the dividend rises by 10% every year. After 40 years you will collect $1,357.80 every year! In cash! And over the whole 40 years you would have collected $14,636, on an investment of only $1000. And this, of course, doesn't even include any rise in the stock price. If you include an average rise in the stock price of 8% a year, the stock will be worth $23,462 after 40 years. Add in the dividends you were paid and that $1000 investment will have turned into over $38,000. And that is with a single, one time $1000 investment. That doesn't even take into account that you will be investing more and more each year. Over a 40 years period, if you continue to add new funds and reinvest the dividends, compounding will make you very wealthy.
G. Stay 100% invested. The market will go up and the market will go down. But nobody can predict when that will happen. If you are going to use a dividend growth plan then you have to actually own the stocks to collect the dividends. If you are out of the market for any reason you cannot collect dividends. So it is my advice to stay 100% invested. You may reconsider this as you get closer to retirement, but while you're young you should stay fully invested. Every quarter take all the money you have deposited in your account (and collected from dividends) and use it to buy dividend paying stocks. This will maximize the amount of dividends you will collect, and over time, with compounding, your returns will skyrocket.
H. Keep costs low. Every time you buy or sell a stock you pay a commission. Over time these commissions, if too high, can cost you quite a bit of money, and lower your over all returns. By keeping the commissions low, by using a discount online broker, and by keeping your number of transactions low, you will minimize these costs. If you buy a stock and hold it into retirement you will only pay a single commission. This will save you a lot of money as compared to trading in and out of stocks. There are no commissions when you collect a dividend.
Summary If you follow these goals, although you may not live the high life in your twenties, you will be comfortable and financially secure, and as you get closer to your retirement you will find that you won't have to worry about money. You will have plenty. And who knows, you may even be able to retire early.
While writing this it occurred to me that the lessons I want to teach my daughter are the same lessons people discuss on SA every day. And the lessons I want to teach her, I'm sure, are the same lessons other parents will be trying to teach their children. I hope by reading this article some people might get some ideas about how to approach this topic with their college age kids. And as I put this article together I came to realize that the lessons I will be trying to teach her are applicable to all of us. College students, young adults, Couples just starting a family, middle age people closer to retirement, and people already in retirement should all try to live by these principles. There is never a time in your life when you should not try to be financially responsible.
I hope that if other people have other ideas for me and my daughter they can let me know in the comments section. I can teach my daughter a lot, but I know I don't know everything, and I'm happy to get whatever advice people can give me.
Thank you for reading my article. I welcome your comments.
Disclosure: I 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. I have no business relationship with any company whose stock is mentioned in this article.