4 Thoughts on Personal Finance & Investing You Have to Know in Your 20s [Part 2 of 2]

Source of image: Pinterest.

Author's note: This is a repost of an article written five years ago in 2016 (but the concepts are still timeless) by Fun Liang on Medium, who has since co-founded MoneyWiseSmart.com and writes there now.

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Thought #3 — Increasing your savings matters much more than anything else now in your early or mid 20s

If you are in your early or mid 20s now, I assume that you do not have a large sum of money that can be invested in the market. By large, I mean an amount of at least $50,000.

If that’s the case for you, let me tell you this. Within the context of personal finance, savings matter much more than anything else to you now!

What matters now is not about finding the best investment strategy or opportunity that gives you the best percentage return. What matters now is finding ways to increase your monthly savings! Be it from cutting down your expenses (e.g. foregoing that cup of $5 latte everyday or reducing the number of beers that you have during Friday and weekend nights) or from increasing your income (e.g. by taking up freelance or part-time jobs).

The reason is straightforward, although many don’t realise it.

If you have an investable capital of less than $50,000, and assuming you can achieve an annual return of 6% from your investment, the returns from your investment would be a maximum of $3,000 for the year, translating into a maximum of $250 per month. A maximum of $250 per month! That’s what you can get from your investment return. I believe there are many ways that you can increase your savings by $250 per month, the most obvious being cutting down on your unnecessary expenses.

The point is, as strong as the power of compounding can be, if your capital is not significant, the amount that can be compounded on is not large, and thus the effect of the compounding or returns would not be significant, when compared to other sources of wealth generation.

As we have talked about in point #1, the effect of compounding only becomes prominent in the long run, not in the short run. Putting it in other words, a snowball rolling down the mountain only achieves a powerful momentum (that can cause an avalanche) when it has become big enough. At the very start, the speed at which the small snowball rolls down and gathers more snow along its way is rather slow.

So, instead of figuring out the best way or angle to roll the snowball down so that it gathers more snow naturally (read: finding the best investment opportunities that can get you an extra 2%, 4% or whatever % you are dreaming for), you are better off spending your time and effort gathering more snow and building up the size of the snowball yourself the old-fashioned and labourious way (read: managing your personal finance, cutting down expenses or taking up more work to increase your income).

To give you an idea of the difference in results between the two, in numbers term, let’s revisit our old friend Bob (with the same numbers as above) and a new friend, Tom:

• Bob is 25 years old and has $12,000 now. He invests that amount, and then saves and invests $12,000 in every subsequent years, with annual returns of 6%. When he turns 55 (30 years later), he has slightly more than $1 million; versus

• Tom is 25 years old too, but due to his careful spending and part-time work in his past few years, he has already accumulated a capital of $62,000 now (i.e. $50,000 more than Bob). He invest that amount and decides that since he had been working very hard in the past few years, maybe it’s time for him to start enjoying his fruits of labour. He starts working less and spending more, so he saves and invests $8,400 in every subsequent years (i.e. $3,600 less than Bob per year, or $300 less per month), with annual returns of 6%. When he turns 55 (30 years later), besides having slightly more than $1 million, he has slightly more than Bob too.

See the difference? Tom has a head start of an additional $50,000, which he accumulated from his hard work and thrifty lifestyle. But he then spends more than Bob in the later years, saving $300 less than Bob every month for the next 29 years. Even though the total capital that Tom put in ($305,600) is about $54,000 less than Bob ($360,000), in the end, Tom ends up in a slightly better position than Bob.

So the point is that, having a large capital (a snowball of a decent size) as early as possible is of utmost importance. If your capital now is not significant, chasing after the “best” investment product or opportunity may not be the most effective way to increase your wealth and the thing that you want to put your most priority on now. You have a more important priority — to increase your savings, either by controlling/reducing your expenses and/or working on additional active sources of income.

Remember: Increasing your savings matters much more than anything else now in your early or mid 20s.

“When he was 23, Eric Haban, a Boglehead and regular contributor to the forum, expressed the idea beautifully when he wrote: “What most young people don’t understand is that SAVING is more important in the beginning than finding the best performing investment. Having the ability to ‘pay yourself first,’ manage your debt load, and determine a vision of what you want to accomplish is vital to your success. I read an article last week that stated 40 percent of Americans don’t know where their earnings go. The simplicity of saving, coupled with the power of compound interest, is something to be very happy about.”” — Extracts from “The Bogleheads’ Guide to Investing”

Now that you (1) understand the power of compounding, (2) learn that time is one of your greatest assets, and (3) learn that savings matter much more than anything else, what’s left?

Remember the simple investing strategy that can provide you with an annual return of 6%, which you can couple with the power of compounding to get you far enough?

If you are expecting me to give you the answer, I am sorry I am going to disappoint you. But what I am going to share with you in my next point is, in my opinion, even more valuable and important than the answer!

Thought #4 — For long-term success in investing, you can’t just chase after the “best” fishes, without learning how to fish properly

That’s the hard but sad truth of life. There is just no free breakfast in this world, or at least not enough for everyone.

Regardless of whether you have the intention to become a professional investor or not, as long as you want to be in this game for the long term, you have to learn the trade. And I say this for good reason.

Think about this. If you chase after the best fishes, without learning the proper way of fishing, how many fishes do you think you can catch? You might get a few good catches now and then if you are lucky, but how sustainable can this be? Remember, if you are investing for retirement, you have many more years to go, in fact, many decades.

Some of you may be thinking now: “I am not so silly to bet my savings on luck. I have a better idea. I don’t need to understand the trade. I just need to follow my “expert” friends or financial advisers — fish where they fish, fish what the fish, and fish when they fish.”

That might work, provided if (1) you can find such people (they are usually highly mobile, elusive and most probably in a different social circle from yours) and (2) you have access to them all the time (they are usually on the go).

The second point is very important. Because if you fish where they fish, fish what they fish and fish when they fish, without knowing exactly how and why they are fishing what they are fishing, and do not have access to them all the time, when the difficult time comes, there is a high chance that you don’t know what to do.

Imagine if you encounter a difficult fish or a seemingly submissive fish that suddenly goes crazy (read: company having financial problems or bad news), or if the sea suddenly becomes shaky with strong waves (read: economic downturn or recession or even depression), do you think you would know what to do? Should you hold on? Should you let out more line? Or should you even let go before your line breaks?

You can try to copy what your expert friends do (or imagine what they would do if you do not have access to them), but what they do might not work for you, because both of you might have different skills and situations to begin with. They might have used fiberglass fishing rods with higher tensile strength lines, or they know that they have the skill and endurance to fight against the monstrous fish, that’s why they choose to fish on. If you are not aware of those and copy them in fishing on, good luck battling the monstrous fish using a bamboo fishing rod with little skill.

So enough of the fishing (I personally have fished only once before using a simple bamboo rod in a small village, so I hope no one mistakes me as an “expert” fisher). My point is, it is difficult, if not impossible, to achieve success in investing over the long term, if you don’t make the effort to learn about investing so that you have full understanding of what you are doing or are planning to do.

When I say learn about investing, I am not talking about complicated stuff like financial modelling, derivative trading, hedging strategies, etc.

I am talking about simple concepts like:

• What is the time value of money?

• What type of investing strategies are there (e.g. technical trading, forex trading, value investing, growth investing, contrarian investing)?

• What asset classes are there (e.g. equities, bonds, real estate, commodities)?

• What are the pros and cons of each asset class? What type of risk-reward does each offer?

• What are the investment products within each asset class (e.g. for equities, they include individual company’s shares, exchange traded funds, index funds and mutual funds)?

• What is portfolio management and how does diversification work (note: putting your eggs in many baskets doesn’t necessary mean diversification if the baskets are quite similar)?

The reason why it is a must for you to understand these concepts to begin with is so that you know what are the options that are available to you in the market and what are their pros and cons, so that you can make active and informed decisions on the type of assets/products that you want to invest in.

You need to have a strong foundation and understanding of the things that you choose, or choose not, to invest in, because without a strong foundation, you would be easily swayed by external happenings and noises as you go (if you are an engineer you know best).

The good news is that these are not as difficult or intimidating as they may seem. They are simple concepts and once you get them, they will stick with you for life.

Maybe in the end, after going through all the trouble to read up on various asset classes and investment products, you might decide to go with a simple strategy of just investing in exchange traded funds (ETFs) coupled with dollar-cost-averaging strategy, which your friend has told you about it long ago (__if you don’t know what are ETFs, what are the pros and cons of ETFs and the things to take note of if you want to invest in ETFs, start Google-ing “ETF” now. It’s part of the process of learning about investing!).

However, this time round, your decision (to invest in ETFs) is an active and informed decision. You know exactly why you are going for them, and why not the other options. You know exactly how they work, their pros and cons, and the reasons why they suit you at this stage.

And when you really know about the stuff, and not “know” about the stuff because you hear from people, that’s a very different (and much better) position to be in, for now you would be more well-equipped to tackle all the monstrous fishes that would appear out of nowhere in your investing journey ahead.

As the famed former Fidelity Magellan chief Peter Lynch says, “know what you own, and know why you own it".

”So if you want long-term success in investing, start taking action to learn about investing now. Make that Google search (there are plenty of good articles on the basics of investing, although you have to read them critically). Pick up that investment book in the bookstore or library. And the next time you meet people who know more about investing, instead of asking them WHAT to invest in, ask them HOW to invest and WHY they invest in what they invest.

Remember: For long-term success in investing, you can’t just chase after the “best” fishes, without learning how to fish properly.

“An investment in knowledge pays the best interest.” — Benjamin Franklin

Summary

To re-cap, here are the 4 thoughts on personal finance and investing that I think everyone should know in their 20s:

1. Don’t rush. The power of compounding, coupled with a simple investing strategy can get you far enough.

2. “Time” is a very important asset of yours. Use it to your advantage.

3. Increasing your savings matters much more than anything else now in your early or mid 20s.

4. For long-term success in investing, you can’t just chase after the “best” fishes, without learning how to fish properly.

Lastly, I would say, if you really want to grow your wealth, focus on saving and building up the size of your snowball now. And in the mean time, take action to learn more about investing, so that by the time your snowball becomes big enough, you already know the best way and best angle to roll (or even, if you like, toss) it down! Happy learning and investing!

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We are sure you will enjoy other investing content (including how to fish and some fishes) at MoneyWiseSmart website too!