Getting Off To The Best Financial Start – Low Cost Advisor
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Opening a checking or savings account is a personal finance rite of passage for many teenagers and young adults. From that point on, though, banking services often become something that people take for granted.
Urban and suburban residents alike pass corner bank branches daily, making it easy to forget the valuable benefits that banks provide—and that seven million U.S. households remain unbanked altogether, according to FDIC data.
By comparison, investment accounts seem to retain an allure that feeds off new trends and technologies. The investment conversations that most excite people, however, rarely revolve around plain vanilla—and also time-tested—investment approaches such as buying and holding low-cost index funds.
Instead, a friend, family member or colleague is more likely to want to discuss Robinhood, meme stocks or the latest cryptocurrency. These stories emphasize dramatic rates of return while downplaying risk and other personal financial considerations.
What bias arises for people who underappreciate their banks and feel FOMO every time they hear about someone else’s investment windfall? For members of Gen Y and Gen Z, who still may be learning how to balance liquid assets and long-term investment goals, the decision process is rife with opportunities but also significant pitfalls.
Before anyone in this group clicks “buy” on an investment transaction—or alternatively—decides to sit on large amounts of cash, it’s valuable to think through the respective roles that bank accounts and investment accounts should play in their lives.
When to Choose a Bank Account
The primary functions of a bank are well known to anyone who has a paycheck deposited into a checking account with some regularity. Ultimately, bank accounts offer a secure place to hold short-term funds, with some insurance protection from the federal government in case the bank fails to perform its essential duties.
Banks are convenient—even more so in the age of online and mobile services—and typically are less expensive than alternative ways to access money, such as check-cashing services.
For people with a positive checking account balance at the end of each month, transferring a set amount of money into a separate savings account can make it easier to grow funds for a designated purpose in the short or medium term. Both psychologically and in practice, it’s easier to avoid overspending and save for an important goal when that money is held separately from day-to-day spending cash.
A high-yield savings account—when interest rates aren’t at rock-bottom levels, at least—can even sweeten that deal with a little extra compounding growth.
Bank Benefits That Fall Under the Radar
The early role that banking plays in a young adult’s personal finance journey means that inertia often sets in after the initial setup. People who open a bank account in college may very well stick with that same financial institution for decades, if only to avoid the hassle of identifying a superior option and moving their accounts. After all, a checking account is a checking account, right?
Yet it’s often not until someone finds themselves in a financial pinch that they realize the additional services that a bank may offer them. The benefits of a good banking relationship fall roughly into one of three categories.
The first category is when a bank customer needs assistance with a financial task that falls outside of the bank’s primary transactional role. Both national banks and regional credit unions have lines of business that extend into other aspects of a person’s financial life. For example, someone who needs the best possible mortgage rate when buying their first home may not think of—or even prefer—their primary bank, but that banking relationship could provide a discounted rate that proves better than other options.
The second category of benefits a banking relationship may offer revolves around convenience. Take, for example, international travel. When planning a vacation to a foreign country, one of the last things a person wants to stress about is being able to access their money quickly and without punitive costs. Yet, not all banks prioritize this service, which means that someone who likes or needs to travel probably should seek a banking relationship that enables them to accomplish these objectives.
The third category is the one of which people often are most acutely aware: avoiding financial pain. A young adult who sets up a personal money management system with one or more bank accounts at its core doesn’t want to feel penalized on a regular basis for using those accounts. From the cost of using third-party ATMs to the penalty associated with overdrawing an account due to an ill-timed transfer or withdrawal, it pays to minimize bank fees and penalties.
The Consequences of Bank Inertia
Even at the most optimal bank for a given individual, the same inertia that applies to changing banks can apply to the dollars within those bank accounts. In a complex and often unnecessarily confusing investment environment, the money within a bank account feels safe—even when that account’s owner knows that the money could be put to a more appropriate use. As comforting as this safety may be, young adults who only keep traditional bank accounts are missing out on opportunities for long-term growth.
Bank account balances don’t rise and fall on the whims of Wall Street emotions. The money is reliably there, day in and day out. And a sizable, and perhaps growing, account balance looks pretty nice, too. But the hesitations that stock market unfamiliarity can cause can have real consequences.
When to Choose an Investment Account
If you ask most young adults, the primary purpose of an investment account is to generate a rate of return superior to other options, most notably a bank savings account. But after this point, their knowledge of investing and its mechanics may become murky, a combination of information provided by various people with mixed amounts of understanding themselves.
The primary shortfall in this knowledge relates to risk and how risk should align with the timing of how someone plans to use the money they invest.
Not all investment accounts and strategies are created equal, which is why people who are trying to grow their retirement savings by day trading can get into deep financial trouble. While this may be an extreme example, some degree of risk applies to all types of investments.
For young adults, one key to investing successfully for their lives is thinking through what level of risk they’re willing to accept to advance their goals. For funds sitting in a bank savings account, this question translates into asking when they think they will want to use the money they invest.
On one end of the spectrum, most young adults are not seeking the investment risk associated with putting their emergency funds or travel funds into the stock market. People may need to access the money they’ve set aside for an emergency, by definition, at any time, which means the volatile stock market is an inappropriate place to park those dollars.
Similarly, if someone plans to travel six months from now, they cannot afford to have the stock market dip in the same week that they need to buy flights or pay for a hotel. In both of the above and all short-term cases, the money intended for these upcoming purchases needs to remain safely tucked away in an “unproductive” bank account.
The outcome may look different, though, when they’re thinking about what to do with medium- and long-term funds.
The Benefits of Investing Medium- and Long-Term Dollars in the Stock Market
Even among Millennials who are dealing with student loan debt and the question of how to afford a home, a common sentiment exists that they need to get better about “making their money work for them.”
They rightly view the stock market as a viable candidate for achieving this objective, but they feel paralyzed about whether they would be making a mistake in chasing higher growth.
The bridge from this initial investing desire to actually contributing some money to a tax-advantaged individual retirement account (IRA) or taxable account seems to lie in understanding how short-term time horizons differ from medium- and long-term time horizons.
A 25-year-old who wants to purchase a condo by the time she reaches age 35 has a long enough runway that she can withstand any near-term craziness that takes place in the stock market. In this case, she can feel willing to accept the risk and volatility that comes with investing her medium-term funds. In fact, she can feel free to ignore stock market news altogether for roughly the next eight years.
Based on her ultimate goal, she just needs to make sure that she has returned those funds to her bank account in plenty of time—roughly one and a half to two years before—to use them for her home purchase. This two-year window should provide sufficient protection since, historically, the stock market has recovered from dips in a matter of months, with only a few exceptions.
A similar logic applies to a young adult who wants to invest his money for the longer term (20+ years) or who has no specific goals on the horizon. So long as the planned uses for this money remain the same—in other words, the timeline isn’t much different—then a low-cost, diversified investment, such as a stock-based index fund, can be entirely appropriate.
When a recession arises or an unexpected downturn occurs, this particular investor can sleep soundly—and stay the course with his money—knowing that he has the luxury of allowing the stock market to recover over time.
The Risk Associated With Misjudging Your Tolerance for Stock Market Investing
For some people, fully embracing and actually sticking with this time-driven investment approach is easier said than done. Anyone who makes these decisions when stocks keep going up may feel confident in the moment that they won’t feel anxious if the stock market enters a prolonged dip.
But it takes commitment, calm and—yes—ignoring most investment commentary to stick with an investment plan during an unfavorable time. For anyone who fears this situation or knows themselves as someone who couldn’t stand to watch their balance fall, stock market investing is probably better done in small doses, perhaps with a large complement of stable bonds as an alternative middle ground.
Compound growth in the stock market is a wonderful thing, but it requires patience, a long-term view and a willingness to ride out the inevitable market dips. If those prerequisites feel too daunting, then your money may be better kept in a bank account or less risky investment. However, there is such a thing as being too conservative when it comes to the longer term.
Even for the risk-averse or reluctant young adult investor, one area in which it pays to take a more aggressive stance is saving for retirement. Investing tools like target date funds and robo-advisors can simplify investment decision-making and, at the same time, may help minimize the likelihood that a younger investor will react emotionally in a market downturn and sell at the wrong time.
Bank Accounts and Investment Accounts: A Delicate Balance
Young adults who don’t feel confident around stock market terms, accounts and platforms deserve credit for nonetheless pursuing new investment opportunities. But whatever stress they feel from watching their savings just sit in a bank account shouldn’t drive their investment decision-making. Bank accounts serve many important purposes, including keeping money safe when someone isn’t yet sure where else it should go.
Once a person has thought through how that money is most likely to be used, their timeline for doing so and how they’ll feel once it’s exposed to the variability of the stock market, then information about how to invest typically becomes much more helpful.
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