Saving Zone #1 - Helping Young People Save
A semi-regular newsletter on personal savings for beginners.
In this series I will provide you with tips and tricks on how to start saving by using the equity markets.
Why even bother?
Bonds, stocks, diversification, dividends, compound interest... you may have heard these terms, but don't know why they're important or what they are used for. As an individual saver (I refrain from using the word investor, because our focus is on saving, not investing) all terms can be relevant, and I'll walk you through them in simple language.
This knowledge will help you in many ways. When the time comes to decide on your pension schemes or 401(k)s, it will be extremely helpful to already have some experience with the markets, and a feeling that you can stand by your own decisions rather than having to trust some banker over the telephone. Financial independence can be more than having enough money not to worry about your future, it can be as simple as trusting yourself with important money decisions. If this series can help even one of you reach this point, my time will have been worth it.
Why am I doing this?
After four years of studying economics at university, over six years of saving in capital markets, and hearing heaps of poor advice from "experts" to beginners, I want to help those who can benefit the most by saving using the markets, and those people are undoubtedly young people!
Why would young people benefit the most?
Here comes our first teaching moment: the mysteries of compound interest. In a simple example put together by Business Insider, assuming a modest annual increase of your savings of 5 percent, if you start saving $300 per month at 25 until you're 65 you have put $144,000 towards your savings, but you can expect to take out $460,000 at 65. However, if you start saving $600 per month at 40 years of age, you put $180,000 towards your savings, but can only expect to take out $359,000 at 65. Doubling the savings per month at a later stage doesn't seem to help...
Why is this?
This is due to the marvels of compound interest. Save $100 today and it grows 5 percent over the first year and you end up with $105. If this sum grows another 5 percent over the second year, you don't end up with $110, but instead you have $110.25. So after 35 years, the original $100 you invested will have grown by $451.6 (a factor of 1.05 to the power of 35!). That's why, if you find a $20 note on the ground, what you're really looking at is $110! (average return of 5 percent each year for 35 years). This is also referred to as interest on interest—the money that is accumulated on top of the original interest that you have earned on your savings.
Compound interest isn't mysterious—it's simple, the earlier you begin to save, the more you can expect to take out at the end of your horizon (the fancy word investment people use to describe the end of their investment period). And don't worry if you can't put away $300 every month right now, the argument still applies—the earlier you start saving the better!
But how do I save using the markets?
Going to the markets to save can be scary, but luckily it's quite easy for young people to get started.
First, you need a savings target
If you put your target too high, you may end up in situations where you have to put your savings on hold for months on end due to unexpected costs, or you become too nervous about the movements of the market that you're causing yourself worry. If you put your target too low however, AKA $0 for most young people, you miss out on all the future benefits.
Second, you need an idea of what risk you are willing to take
This is up to each person to decide, but it is important that you are aware of the risks that each asset may entail. Smaller companies tend to be more risky, whereas larger ones are more "safe". Assets like gold and silver have traditionally been considered safe and offered decent returns for savers. Indices like the S&P 500, OMXS30, FTSE 100 also belong to this category of traditionally safer assets, because they track multiple large companies. Over time, they have also produced returns exceeding the 5 percent example used above.
Third, you need to identify assets to buy
This is a tricky part where most people stop and turn around. My advice to beginners is to find a couple of broad and safe products to start with. The key here is again to buy products with low fees. If you are buying mutual funds or market tracking funds, the provider will usually take a yearly percentage fee for the maintenance of the fund. In every asset category, we want this percentage fee to be as low as possible. Why these fees vary is a topic which we will discuss later.
A beginner's monthly purchase for a Swedish saver could look like: $33 of the OMXS30, $33 of the S&P 500, and $33 of a global mutual fund. (If you're in Sweden, Avanza has a free global fund and a free OMXS30 fund). A word of caution: an investment expert might scream with fear, and say this is not a great portfolio, because you're not spreading your risks properly. My argument for a purchase like this is that the most important thing for a young person is simply to start saving. With time, you'll learn more about your risk appetite, and the companies that interest you and you'll make more educated decisions on what asset to save with.
Another argument for this purchase is that in most cases it is better to be in the market than outside of it. This is because, normally, the largest stock value increases occur on just a couple of days during the business year, and being able to time these days is impossible (literally, proven to be impossible or down to simple luck). Since we are casual savers we are not trying to time these good days and so it is better for us to be in the market than outside it.
Fourth, you need a Broker
If you're in Sweden, I recommend using Avanza or Nordnet as your broker. If you're in the US you can use app services like Robinhood, which lets you access the markets easily. The key thing to watch out for when beginning to save is fees. Traditional banks usually have unreasonable transaction fees whereas internet-based brokers are cheap. An acceptable transaction fee on a small stock purchase (around $300) is anything below 1 percent. My transaction fees with Avanza in Sweden are 0.3 percent, but I understand that fees may vary in different countries so make sure you do your homework before picking a broker.
But what if my money doesn't grow, and instead the assets I buy decrease in value??
Ah, yes, the fear of a market-wide drop, or bear market as it is often called. This is where the fifth, and perhaps most crucial, point to a long term casual savings plan comes in. Your savings target needs to be realistic and achievable.
You want to save without the worry. Markets will go up, and they will go down. If you save in broad funds and indices, it is not uncommon for the value of such a portfolio to drop by a third in a recession. However, with a good savings target, you stick to your monthly purchases, which means that during a recession you will be buying quality stocks at low prices. In the long run, this will help compensate your original losses once the recession ends.
Also, keep in mind that your horizon is long, and that negative movements like recessions are inevitable, but mostly unimportant to the final sum of your savings in the grand scheme of things.
Again, we arrive at the conclusion that being in the market is better than being out.
There are plenty of resources on the internet to find a broker which suits your needs. Look into these, and then find what sum you are willing to put away each month. Don't worry about starting with a modest figure like $100 or even $50—anything goes. After you have done this, you are ready to start saving! Completing a purchase like the example portfolio above will never be optimal for your risk profile or personal targets, but it will provide a hassle-free start, which will not cause you any unnecessary worry. Remember to carefully read the fee structure of each asset and minimise the fees you pay yearly.
In the meantime, I will write more articles to help you improve your future savings. Thanks for reading.
I have a B.Sc. in economics from the University of St Andrews in Scotland. I obtained a first class degree and was awarded a price for the best student in Financial Economic Theory of my class. I have interned with a bulge-bracket bank in London, and I have been saving using the capital markets for over six years.