The greatest part about being a young professional when it comes to investing is the “young” part. Typically, the more time you have to invest, the wealthier you can become. This is because of a few reasons. One is the magic of compound interest, as you’ll see below. A longer time horizon also allows you to take a few more calculated risks in your portfolio as opposed to someone that is about to enter retirement and will need that money to live on a day-to-day basis. Taking advantage of some of the tax-sheltered accounts offered in Canada is another great way to grow your portfolio as much as possible.
First off, I want to start by saying that when I write that you can take more risks I don’t mean that you should put yourself into the most high risk/potentially high reward investments. Things like penny stocks, speculative investments, and similar products aren’t designed for most investors and are not a viable long-term strategy because of their volatility. I’m referring to how your overall portfolio is structured. A young professional with time on their side should use this to their advantage to seek out different investment options that can offer solid above average return while still maintaining stability and predictability.
Unless all you do is purchase GICs from the bank, every investment that you ever get into will have an element of risk to it. While some are more risky than others, the most important thing is to manage the risk as much as possible. One of the best ways you can do this is by educating yourself on what you’re investing in. If you don’t understand an investment or it seems overly complicated, then don’t buy into it. Following this one simple strategy will help you steer clear of certain investments that you probably don’t want to get involved with in the first place.
A portfolio that is too conservative can also be just as damaging as one that’s overly aggressive. If you have 20 years until retirement, it doesn’t make sense to have most of your investments in super low-risk products that only earn a few per cent every year. By the time retirement comes around, you won’t have taken advantage of compound interest and inflation will have eaten up a lot of value in the portfolio. Depending on overall investment goals, there will always be a comfortable balance between return and risk that any investor can achieve from the guidance of the right financial professional.
Because you’re a young professional and you have time on your side, one of your best friends is going to be compound interest. I’ll give you a simple example that will show you why: Say you agree to lend someone $1 for a year at 100% interest. Using simple interest, at the end of the year you would receive $2 (your initial $1 back plus an additional $1 of interest). If we compound the interest semi-annually (twice per year), at the six-month mark of the $1 loan, interest is calculated and added to the original loan amount, bringing the value of the loan to $1.50 ($1 loan plus half a year interest). When the second half of the year is completed and the loan is due, the interest is now calculated on $1.50 rather than on $1. The balance due is now $2.25 ($1 loan plus $1.25 interest). While a 25 cent difference may not sound like a big deal, remember that this was off a loan of just $1 and for only one year. Start calculating with larger numbers and time horizons and it quickly becomes apparent how much of an impact this makes on your portfolio long-term.
RRSPs (Registered Retirement Savings Plan) and TFSAs (Tax Free Savings Account) are designed to help individuals grow their investments even more by sheltering capital from taxes. The major difference is that in an RRSP, you pay taxes when you withdraw that money in the future (most likely in a lower tax bracket) while a TFSA can be withdrawn at any time without any tax consequence. Contribution limits change every year for an RRSP account but is capped at the lower of 18% of your gross income or $23,820 for 2013. Any amount that you don’t contribute can be carried forward for future use. For a TFSA account, you can set aside up to $5500 a year, and like an RRSP, can also go back and use any unused room from previous years. Because your funds get to grow tax-free in these accounts, they create a fantastic opportunity to really accelerate the principal of compound interest and grow a solid nest egg for the later years.
For some young professionals, the concept of retirement seems (and might be) decades away. No matter how far off, it’s never too early to start planning and setting yourself up for a successful and comfortable life after work. A few small steps now can make a massive difference. I’ll finish off the article with a real world example. A person who is 30 years old and invests $3000 a year for ten years, but then never makes another investment, will have $80,000 by the time they are 55 if they get an average return of just 5%. If that same individual invests the exact same way but only starts at 45, they only end up having approximately $38,000 by the same age. Same $30,000 invested, same returns, but the person that started investing earlier comes out ahead by $42,000! That should give you some strong motivation to take that retirement plan from your head and put it into action. Happy investing.
Article by MP Private Capital Founder Mitch Parker