Pimp Your Finances

I just read a great article by Ron Lieber titled “Legacy of a Crisis: A Generation Shy of Risk“. It’s about the mental impact that the recession is having on the younger generation.

You did what you were supposed to do.  College. Graduate school, maybe. Bought a home. Invested in mutual funds.

And now? You have student debt.  Your degree has not shielded you from unemployment. The house is worth 20% less than two years ago, and your retirement portfolio is down 40% from its peak.

While this isn’t an unusual situation for anyone, it’s especially dangerous for younger people who are just getting started in the world of finance. 

We have less to lose money-wise, but we’re also at a delicate and impressionable stage.  Many young people will get burned, and some may resort to a lifelong pattern of fear and risk aversion.

Do not avoid risk - or insult Ukraine

The author agrees, and asks his readers:

Are we in the process of minting a new generation of adults who are averse to taking chances, whether it’s buying real estate or investing in stocks?

It’s too early to tell how anyone – let alone young adults – will respond to the financial crisis, but there are already some troubling signs.

According to a study quoted by the article, only 45% of young households (defined as under the age of 40) have a majority of their investments in stocks instead of bonds.  While it may not seem shocking on its own, its worth noting that more than 50% of older households (ages 41-64) choose a more aggressive portfolio consisting of at least 50% stocks.

That means that older investors – even those close to retirement – are investing more aggressively than young people.

Another indicator is a survey of a financial management class at De Sales University.  The class was asked what portion of their portfolio they would invest in stocks.  Even though this was a class of  informed and well-read students, most of the class said they would put less than half of their money in stocks.  When asked for the reason why, they cited fear of job loss, lack of morals on wall street, and general economic fear.

This is counter productive.  The time to have been conservative would have been when you expected the markets to go down.  Not after they’ve already crashed.

Why would you consider taking less risk NOW after most of the risk has already been paid for in the market over the past 12 months?

Of course, you should only make decisions based on what you think your investments will do in the future…not what they’ve already done.  But for younger investors, being overly cautious can be worse than being too aggressive.  Keep in mind the following facts (all according to the Oblivious Investor):

• Inflation averages 3.25%
• Bonds earned an average return of 5.2% from 1928 to 2008
• Stocks earned an average return of 9.07% from 1928 to 2008

That means that after inflation, bonds return 1.95%, while stocks return 5.82%. The percentages don’t give a good indication of how much being cautious can cost you though.

Instead, I’m going to give an example. I’m assuming that you start with $10,000 in your 401K, and contribute an additional $200 a month for 30 years. For the math, I relied on a calculator from the Suze Orman’s Young, Fabulous and Broke website.

If you invest exclusively in bonds, you’ll have a total of $115,772 after thirty years:

Invest exclusively in stocks, and you’ll have $244,160:

I know that is oversimplifying things a bit, but still – you’ll have 110% more with the aggressive portfolio. That’s a huge difference, especially considering that stocks only return about 4% more per year.

To be fair, the difference may or may not be that big over time. You’re likely to invest more than $200 a month, but you’re also probably going to gradually convert more of your portfolio from stocks to bonds each year. But the point is still valid – you’re missing out if you’re too conservative.

Many investors are afraid of losing money, so they keep out of stocks. Ironically enough, they end up missing out on even more money by doing this.

I’m not suggesting that you invest only in stocks, and I’m not telling you to stay away from bonds. My point is that any decision you make should be motivated by reason. Don’t sell yourself short by giving into fear and emotion.