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Savings Strategies for Teens
by Gary Foreman
Dear Gary: Do you have any advice for a teenager with a steady job who
would like their savings to grow. I have paid for my college education
without taking out student loans. I contribute to an RRSP and I
carefully keep track of all my income and expenses. I am not sure what
to do with my savings...I set aside 10% of my income but it is currently
in a basic savings account because I don't know what to do with it...I
was wondering what the best investment strategy would be for someone of
my age. Any help you could give me would be great!! ~ Anita
Wow! Anita sure is off to a good start. Contrary to what a lot of people
think, the young adult years are often the easiest time to save money.
They often see their income grow faster than their financial
responsibilities. That gives them an excellent opportunity to save.
Anita has already started down that path. So what's the best place for
her to park the 10% of her salary that's she's saving?
The answer to Anita's question has less to do with her age than what she
plans on doing with that savings. The decision making process is the
same for any age. The first thing Anita needs to do is to decide what
she's saving for.
Why is that true? Her use will determine how quickly she might need it.
And, that urgency will affect her investment choice.
Let's look at two simple rules of investing. First, you earn a higher
return by assuming more risk. For instance, stocks are riskier than
savings accounts.
The Journal of Financial Planning cites studies that show the real rate
of return for the S&P 500 (stocks) from 1950 to 1999 was 10.3%. At the
time this was written, a short term CD (6 months to a year) would pay
about 4.0% and a five-year CD closer to 4.5%. An interest bearing
checking account earns 1.0% while money market funds are about 2.8%.
So the earnings difference can be significant. To illustrate, suppose
that Anita puts away $1,000 each year for the next 50 years (ages 20 to
70). If she earns 2% on the money at the end of that time it will be
worth $89,000. But, if it earns 10% it will grow to $1.4 million. Quite
a difference!
That means we need to learn about the second rule of investing: risk can
be minimized. Either by diversification or through a longer time frame.
Diversification is a fancy word that means owning more than one stock.
If all of your money is in one company and the stock goes down 50% you
have a disaster. But, if you spread your money among 10 different stocks
and one drops 50% you've only lost 5% of your investment. Not nearly as
bad. In fact, it's possible that one or more of the other stocks could
go up and offset the loser.
The longer time frame reduces risk much the same way. The stock market
does have bad years. Sometimes even two or three in a row. But, for the
last 100 years, if you took any 10 year period, the return was positive.
So you might have lost money in one year. But if you could afford to
wait awhile to sell, you would have gotten the losses back.
Combined, time and diversification allows Anita to get the higher
returns without increasing her risk.
Now let's apply all of this to Anita's situation. We'll assume some life
events. The first reason that she might need to access her nest egg is
for an unexpected bill (think auto repair). For that she needs money
that's accessible immediately. Like in a savings or checking account.
Once she's saved more than enough to cover immediate needs she's ready
for a second investment account. Suppose Anita is also be planning on
buying a new car or making a down payment on a home in two or three
years. Savings earmarked for those purposes would earn more if they were
put into CD's.
Longer term, Anita will want to save for her retirement. She already has
an RRSP account. For our U.S. readers, an RRSP (Registered Retirement
Savings Plan) is a Canadian account very similar to an IRA. A mutual
fund investing in stocks would be an appropriate selection here.
Anita is off to a fine start. All she needs to do is to decide why she's
saving, how much she needs for that purpose and then select the type of
investment that matches her goal. At the rate she's going in a few short
years she'll be giving others advice on how to accumulate money!
About the author
Gary Foreman is a former financial planner who currently edits
The Dollar
Stretcher website and newsletters. If you'd like more time or money,
you'll find hundreds of articles to help stretch your day and your
dollar. Visit today!
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