As a soon-to-be college graduate, I have enjoyed watching many of my peers work tirelessly toward promising and lucrative career paths. While we all desire to take advantage of these opportunities to set ourselves up for long-term financial success, I have observed varying levels of uncertainty and doubt about the best practices to achieve this lofty (yet attainable) goal. Growing up in the information age, we have been bombarded with financial advice from television news pundits and self-proclaimed social media gurus. To make matters worse, this advice is often accompanied by a smattering of negativity and doomsday scenarios to gain clicks and views. These trends have made forming a conclusive decision-making process around our personal finance issues difficult. However, in the following brief text, I hope to instill a sense of optimism and detail several initial actionable steps toward achieving financial independence.
A Stock-Market Reality Check
Since the turn of the century, the stock market has experienced massive downturns due to events such as 9/11, U.S. involvement in two protracted wars, the Great Recession of 2008, and COVID-19, to name a few. While these events created short-term losses at the time of occurrence, the S&P500 has increased in value by nearly 300% over the entirety of the 23 years. Despite temporary setbacks and frequent volatility, this growth has been primarily driven by innovations from America’s best companies that continue to change our everyday lives radically. Innovations such as the emergence of smartphones, the Internet of Things, massive increases in computer processing power, streaming services, and many more are testaments to this.
The stock market (as represented by the S&P500) is a group of companies with the world’s most competitive products and best management teams while also having their accounting and reporting governed by regulatory authorities. Since its inception, the S&P500 has never produced a negative return over a 20-year period. Because of these facts, we want to be long-term owners of these companies and their earnings streams. While we can almost certainly depend on future recessions and volatility with unforeseen causes, we can trust in America’s top companies to innovate and overcome these challenges to drive profits and growth in the long term. The most timeless strategy to build wealth is to use our income to purchase diversified ownership of these companies over long periods of time. Below are three steps you can implement now to do so.
1. Establish a Savings Rate and Maintain Savings Accounts
A savings rate is simply the percentage of monthly income dedicated to being saved before discretionary spending and paying expenses. Once a savings rate has been established and you know exactly how much monthly income you are committed to tucking away, you can work backward to determine what is available to spend in all other categories of life. The importance of defining a savings rate before building the rest of the budget can be summarized with the adage, “Pay yourself first.”
Sticking to your chosen savings rate will, of course, require discipline, but having a set goal from the beginning will make it much easier to adhere to. Your initial savings rate does not have to be high and can even be as low as 5%. Yet creating the habit early will allow you to increase your savings rate as your salary grows. Furthermore, the savings rate should be the first thing you increase as your salary grows before deciding to spend more in other areas.
Luxury can be defined as “the state of great comfort and extravagant living.” Something we are all excited about is establishing ourselves after graduation. The apartment and lifestyle we choose should be fun, yet we do not need luxury at this point in our lives. Therefore, a more philosophical definition of savings that emphasizes prudent spending is:
Savings = Income – Ego
Saving capital each month is the first step in the process, but maintaining these savings accounts is equally important as it will create flexibility. Life will undoubtedly bring unexpected surprises and expenses. Before investing your money, you should have a comfortable amount saved to cover unanticipated costs. Due to the long-term nature of equity investing outlined in the preceding paragraphs, it is important to have funds available to cover such costs to circumvent pulling capital out of the market at inopportune times or taking on debt.
2. Avoid Debt
One of the most essential habits to form for long-term financial success is avoiding spending money you do not yet have. We all know of a friend or acquaintance in college who maxed out a credit card for their spring break all-inclusive cruise or to attend a three-day musical festival. However, the temptation to spend money we don’t yet have will only grow as we move through life. Open any social media app of your choosing, and you can see pictures and videos of someone sitting on a beach in Cancun while you sit at your office desk. Furthermore, large expenses such as traveling to and attending friends’ weddings are on the horizon.
Psychologically, debt allows for the emotional high of attaining something new without the pain of parting with your money. However, like everything in life, nothing is free, and this money comes with a cost. The compound interest on these short-term fixes multiplies debt at an accelerated rate by charging you interest on the interest you already owe. For example, let’s say you owe a principal of $1,000 at an interest rate of 24.52% (the national average for credit cards) and pay only the monthly minimum of 4%. In this scenario, it would take two years and seven months to pay off the original principal AND additional interest of $361.44. While the $1,000 may have felt free, it actually cost you an extra $361.44 and untold stress.
While taking the occasional vacation and being a part of the key events in your loved ones’ lives is deeply enriching, the expenses of these occasions need to be saved and budgeted for to be enjoyed to the fullest. It would be an incredible shame to take on debt to attend an event such as a wedding, only to be consumed with how you will pay it off instead of enjoying the event carefree. Instead, having the peace of mind that you did not jeopardize your financial health could make it even more rewarding.
3. Make Roth Retirement Contributions
A Roth 401(k) is an employer-sponsored retirement plan that allows you to contribute a portion of your wages to an investment account. These plans offer several advantages. The first advantage is that many employers offer matching contributions, which is free money added to your pocket that you would not otherwise receive from salary alone. Employers will typically match a percentage of their employee’s contribution up to a percentage of their salary. Let’s say your employer offers to match 100% of your contributions up to 3% of your salary (a standard practice). In this scenario, with a salary of $60,000 a year, if you max out your matched contribution of $1,800 (3% x $60,000), your employer will also contribute $1,800 to the account. This is a massive advantage because you will effectively receive a 100% return on your money simply by taking advantage of your employer’s matching offer. Consider investing these contributions into funds that will give you broad exposure to the market.
The second advantage of a Roth 401(k) plan is that these contributions are funded with after-tax dollars, meaning income that you have already reported and paid taxes on. While this may seem counter-intuitive to consider an advantage, if you are a young investor early in your career, you are most likely in the lowest tax bracket you will be in for the duration of your career. Investing in a Roth while in a lower tax bracket will allow you to maximize the return for each dollar invested by paying less taxes in the long run. This is a stark difference from a traditional 401(k) plan, which is funded with pre-tax dollars but is taxed as regular income upon distribution later in life when you could be in a much higher tax bracket. While it may be tempting to defer taxes to later in life, $1,000,000 tax-free is much more money to spend in retirement than a taxable $1,000,000.
If your employer does not offer a retirement plan, you can easily build your own by opening a Roth IRA and contributing to it as you get paid. However, this option lacks the benefit of having a company match.
While sticking to a defined savings rate, avoiding debt, and making Roth contributions (IRA or 401k) will not alone be enough to achieve financial independence in retirement, you will begin charting a course for success by taking these initial steps early on. I look forward to growing my professional skills in financial planning to make myself a valuable resource for my friends, family, and colleagues now and well into the future.