“A penny saved is a penny earned” is smart, but it is too simplistic. Middle school children should understand compound interest, and adults should know how to allocate assets according to their risk tolerance and timeline. There are different ways to invest at every age that can build a secure retirement. Remember that what’s below is general information, not intended as investment advice. Contact a licensed financial advisor for help in devising a financial plan that’s right for you.
Understanding Types of Investments
Most people understand savings accounts and the concept of earning interest on saved money from elementary school. Even if families have little or nothing to save after paying the bills or enduring prolonged unemployment, saving and earning interest should be a goal.
When times are good and jobs are plentiful, young working adults can begin using different kinds of investments to build wealth. The first place to look is at employer retirement plans (usually 401(k) plans) that offer the opportunity to invest money on a pre-tax basis in a selection of mutual funds composed of stocks and bonds.
These can fluctuate in value, but they can also grow through capital appreciation, interest, and, in the case of stocks, dividends. These additional funds, in turn, can be reinvested to compound their growth.
Some employer plans include the option to use part of the savings to establish an IRA (individual retirement account) or an annuity as a part of the retirement plan. These also accumulate capital gains, earnings, and interest over time.
Understanding Risk Tolerance and Asset Allocation
The percentage of money invested in different types of financial instruments is called “asset allocation.” Younger people have more time to allow for capital appreciation, accumulation of dividends and interest, and the effects of compounding through reinvestment, so they can take greater risks as a result. If the value of financial assets falls, it can recover over time. This is why young adults can invest more aggressively in stocks over more staid income investments like bonds.
As people age and get closer to retirement, asset allocation becomes more conservative and risk tolerance declines. In middle age (after around age 50), smart investors direct more of their money toward safer, income-producing investments like bonds. At this stage, there is more to lose. The idea is to keep earning returns but in a safer, less volatile, and more reliable way so that there is enough money to last for the rest of life after retirement.
The Importance of Diversification
“Don’t put all your eggs in one basket” is actually good investment advice—it is a way of describing the strategy of diversification. Spreading investments across various types of industries and different financial instruments is a hedge against hard times, and it is an important way to invest at every age. Certain speculative companies roar during economic booms but crash during hard times, when they are supplanted by “defensive” investments (for example, when toilet paper and disinfectant wipes suddenly became scarce commodities). Diversification, or spreading investments out over various industries and types of investments, can mitigate the effects of market swings.