In my experience most young people don’t know what to do when it comes to their finances, either after high school or college. It is certainly difficult, as this isn’t taught in schools. Most young people have some idea of career options, but don’t know how to arrange their finances to sustain long-term success and eventually, financial independence. I think it is important to understand things such as debt, compound interest, different asset classes, and the wealth building power of high quality, cash generating assets.
The first item to get control of is debt, if you have any. If you don’t, congrats! You have a great head start, but are in the minority. If you have any high interest debt, work as hard as you can to get rid of it as fast as you can. It is impossible to be financially successful paying 15-20% interest on a credit card. Make big temporary sacrifices, and try to never carry a credit card balance. If you have any type of consumer debt, (financing purchases of clothes, furniture, electronics, etc.) work to pay that off as soon as possible. If you are deep in high interest debt, know that it is likely to take much longer to get on your feet financially. Other debts such as student loan or mortgage debt that have a long-term fixed interest rate that is tax deductible, can be paid off over time. Obviously, it would be better to be debt free, but after high interest debt has been paid off, there should be no immediate urgency to pay off the the low interest debt, although it should still be a long term goal.
The next item is to build up six months worth of living expenses in case of job loss, medical emergency or some other life event. This money should be deposited in a FDIC insured savings account with a reputable financial institution. No matter how tempting, it should not be spent or invested. It would be better to have twelve month’s reserves, but starting out with six month’s reserves should suffice.
After those items are taken care of, its time to start building up the investments! This area is where an individual builds his or her way to financial independence. There are three levers to financial independence. The first is how much income you are able to make. The second lever is how much of that you are able to save. The final lever is the rate of return you receive on your invested capital, assuming you are able to save some of your salary and invest it. The honest truth is that it will take a long time to achieve financial independence unless you make a large salary, are an extreme saver, or receive some sort of a large windfall. But with patience, discipline, and knowledge financial independence is attainable over time.
Most people will need to get a solid rate of return on their investments. Even if you make a very large salary over many years it is nearly impossible to get ahead if you are stashing all or nearly all of your money in a bank account earning .1-3%. This is not to say you shouldn’t have some money in the bank, such as the emergency fund. Once that is taken care of, you need to own productive assets. What are those? In my view, they are assets that increase in value and return some cash to the owner usually in the form of rents or dividends. The two best in my view are stock ownership and real estate ownership. Private business is another category, however that is not accessible to most people unless they are accredited, meaning they have at least $500k-$1m to invest, which doesn’t apply to most people. The easiest and most accessible place to invest is the stock market. If your company has a 401k plan, this is a good place to start. Always if you are able contribute the maximum that the company will match. I.e. if the company matches the first $2,000, always try your best to contribute at least that amount. If you don’t, you are giving away free money. You are guaranteed a 100% return on your money with the free match. That is a great deal!
After you have funded your retirement plan to the max, (hopefully) if you are in the position of having money left over, you now have several options. You can save up for a down payment on a home, save up for a down payment for a rental property, buy stocks in a taxable brokerage account, or do some of all three. If you opt for the brokerage account, go with a reputable company such as many of the large financial institutions. Don’t go with a cheap online brokerage that has minimal history. Safety of your hard earned money is important.
After you have opened the account, there is a dizzying array of products offered for your investment dollars. The products include such things as stocks, bonds, commodities, options, forex, futures, etc. The easiest thing to do if you want exposure to stocks, but don’t know much about them is to buy what’s called an S & P 500 index fund. It is a collection of roughly 500 of the most prominent companies such as household names like Facebook, Google, Exxon Mobile, Johnson and Johnson, etc. To invest in an index fund, you don’t have to know much about stocks or follow the market. You can go on living your life while diligently and consistently investing surplus dollars into the fund. Don’t be discouraged if at first you aren’t contributing much. $100 every two weeks for 40 years at a 9% compound interest rate, which is roughly what the index has returned over the years, will come out to $960,000. If you think you can’t afford to save $200 per month, try to figure out a way to cut back on something. If you look hard enough, you can usually find something in your life you are spending money on that isn’t necessary.
Get debt under control, build up emergency savings, save some of your salary to contribute to your retirement accounts, then save for a down payment on a home, save for a rental property, or open up a taxable brokerage account. I know, that is certainly a lot of things to accomplish. To make an analogy, getting in financial shape is a lot like getting into physical shape. If someone is overweight and hasn’t eaten healthy or exercised much in their life, they are not going to get into great shape in a week or a month. However, if they slowly chip away at it over time, they can achieve great results. Much like eating vegetables and exercising, saving money and cutting back on expenses isn’t much fun, but is necessary if someone wants to improve their financial life.
Earlier I mentioned investing in real estate as an option for some people. Rental properties are certainly a great way to build wealth. However, I just wanted to issue a word of caution about rental properties: They require a little bit more of a specialized knowledge as well as a greater time commitment not only setting up the investment, but managing it too. For those who are somewhat entrepreneurial this is an option, for others who have children or are working on their career and don’t have a lot of time, it’s probably better to stick with an index fund in a taxable brokerage account.
Even if you cannot accomplish all of these tasks right away, get started! Even if in the beginning it doesn’t feel like much is happening, stick with it. The alternative is to have a mountain of debt and to be living paycheck to paycheck. That will cause a lot of stress and hardship in life. Start changing your lifestyle, commit to it for the long term, and much like someone starting to exercise and eat healthy, you will notice a big difference over time.