The first rule of compounding: Never interrupt it unnecessarily - Charlie Munger
You generally have to be 18 before you start investing (USA, UK, Australia, New Zealand for example), so we'll start from that age to avoid the complications surrounding investing as a child.
So you have started working, you now have a little income that you're putting aside which you would like to invest. This article discusses the different options available and the pros and cons of each.
Start investing as early as possible. Compounding interest is powerful, and we'll talk about that first after the TL;DR.
Article too long? Here are the key options in order of this author's preference:
An 18 year old has the power of compounding on their side. Starting as soon as possible is key, the earlier you start the bigger the returns as compounding interest begins to give staggering returns. Choosing a low cost Exchange Traded Fund would have been your best option over the last 30 years.
The real power of investing when you are 18 is compounding.
Lets take an example of an 18 year-old who has just started working. Let's say they started investing in 1990 and were able to put $500 away each month for the first 10 years. After 10 years (in the year 2000) due to an increase in income they doubled their savings to $1,000, $1,500 10 years further on (the year 2010 onwards) until in 2020 when they upped it to $2,000.
Say we started putting all those savings into an ETF that follows the S&P 500 index (IVV on the ASX). And in the first year of investing we put $1000 in. In summary:
The results of compounding are truly remarkable and hard to visualise until you actually plug the numbers in and run the experiment. The percent return values for the S&P 500 used above are the real numbers for the S&P 500 over those years. They're taken from macrotrends historical annual returns data.
You might be thinking something along the lines of 'I am 18, I earn very little, it's not worth saving what little I can from what I earn now. I will wait until I'm earning more money to save and invest'. Well let's run that experiment.
Even though you started with a much large initial investment and your monthly investments are double that of what you can invest when you're younger, you end up with a little over half the total than you would have had you started earlier.
The power of compounding means that you will never catch up. Even if you where to put more money away each month it is not going to beat the interest accrued on a larger portfolio.
Where is the best place to put your money? Let's have a look at some options:
An index fund is a portfolio designed to track a market index such as the S&P 500. Index funds may be traded on exchanges, where units of them are sold as shares (that's when we call them an exchange traded fund). They typically have very low management fees as all it is designed to do is buy and hold companies listed in the index they follow. Read more at Investopedia.
A mutual fund, on the other hand, is an actively managed portfolio run by fund managers who select groups of individual stocks, bonds and other market instruments (such as derivatives). Mutual funds have a wide range of goals and risk profiles from 'safe' - mixed bonds and equities, to higher risk - higher proportion of stocks and use of derivatives. Read more at Investopedia
The main take-away here is that approximately 80% of mutual funds do not out-perform the market (Source). Meaning you are likely to get a higher return if you put your money into an index fund.
Real estate investing can fall into two main categories, capital growth or rental yield.
Capital growth: similar to growth stocks, the aim of investing in real-estate for capital growth is to buy low and sell high. In general this means buying real-estate in a high growth area and holding that property until the price has accrued enough that you make capital gains (i.e. you can sell it for more than you bought it for).
NOTE: we're not including a returns chart here because the figures vary so much between location and it could be very misleading. Real estate returns is left for discussion in a future article.
Rental yield: similar to value or dividend stock investing, rental yield aims to buy properties with the main intention to rent them out to tenants. A good practice of this method is to purchase property where the rental income is enough to pay off the loan used to purchase it. In the long run a good rental yield property will generate an income. There will often also be capital growth but this is generally not as much as properties in high growth areas.
Whether you chose growth or rental yield the main difficulty when getting into real-estate is you need a deposit in order to get your first loan. Depending on where you live your initial deposit may need to be as high as 20% of the purchase price. If you're buying a place for $200,000 that comes to $40,000 not including lawyer fees and taxes.
The big benefit of real-estate is that when you're established in the market you can then use the increase in equity on the property to borrow more money and purchase more property. You, in effect, are using the bank's money to invest. At a certain point you don't need to use any of your own money to purchase more properties (leverage).
Term deposits at the time of writing are the safest and lowest return option. It is regarded as 'safe' because your money and returns are guaranteed. Due to the 2008 financial crisis recent interest rates have been incredibly low, and as a result returns from term deposits are extremely low. Check out the chart below which shows the returns on $1,000 since the 90s.
NOTE: Interest rates are drawn from Certificates of Deposit in the US. Source.
Compare the returns you would have gotten having put $1,000 in an S&P 500 index fund over the same period. $2,400 vs $10,600.
Inflation is the decrease in currency purchasing power over time. Have you ever heard an old person say something along the lines of 'in my day a gallon of petrol was 30c!' The reason prices were so low was because the intrinsic value of the fiat currency (like the USD) was more back then. A dollar back then could buy way more than a dollar can these days.
Since the 2008 financial crisis interest rates have been extremely low, so low in fact that they're much lower than the inflation rate. The upshot of which is that the interest rate you will get on a term deposit is much lower than the rate at which your money is devaluing. So in effect putting your money in a term deposit since 2008 is a losing strategy.
Avoid term deposits until the interest rate increases and is greater than the inflation rate.
Compounding is the real allie of the 18-year-old investor. Starting to save and invest at such a young age will set you up for a comfortable future of amazing compounding returns.
“Despite some severe interruptions, our country’s economic progress has been breathtaking. Our unwavering conclusion: Never bet against America,” - Warren Buffett
Investing in a low cost index fund, like one that tracks the S&P 500, has been a winning strategy for the last 100 years. As Warren Buffett often says, this strategy is likely to keep winning. Even though Buffett has made his fortune investing in individual stocks he always recommends people invest into the S&P 500, betting on the US economy.
Mutual funds are not recommended due to the highly variable returns and difficulty selecting the correct fund. High fees will also eat away at profits and most funds do not outperform the S&P 500.
Real estate should be part of your portfolio in the future but is much more difficult for an 18-year-old to get into due to the high initial deposit.
Term deposits have had terrible returns over the last 12 years due to incredibly low interest rates. As of the time of writing it is a poor option. This may change given we are now starting to see high inflation rates which in turn may increase interest rates and returns on term deposits.
Disclaimer: This article represents the views of the author, and any investment decisions made should be discussed with a qualified financial advisor. While every effort has been made to ensure that the information provided is accurate we give no guarantee that this is the case.
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