3 Things Young Adults Need to Know About Building Wealth
Aristotle once said, “The roots of education are bitter, but the fruit is sweet.” This wisdom is still relevant today, even more so than in Aristotle’s time when discussing financial literacy.
Excuses are abundant when trying to comprehend why Americans don’t take better care of their money, but the source of the problem appears to be a distaste for education. As a nation, we consistently flunk the understanding of basic financial concepts. A recent study from the American College of Financial Services finds that eight out of 10 retirement-age Americans with at least $100,000 in assets failed a basic quiz on how to make their nest eggs last throughout retirement. Only 7% of respondents in the study scored a C or better.
Even with modern-day advancements and accessible education, America’s largest generation is failing to understand financial issues. The Financial Industry Regulatory Authority (FINRA) finds that only 24% of millennials are able to correctly answer four or five questions on a simple five-question financial literacy quiz. That figure drops to just 18% among those from 18 to 26.
The Cheat Sheet spoke with Andrew Ferraro, CFP, CIMA, a Wealth Advisor at Strategic Wealth Partners, to better understand how young adults can improve their financial literacy. Let’s take a look at the top three things you need to know about building wealth and planning for retirement.
1. Understand net worth
In order to create wealth for the future, you need to manage your personal cash flow so you have a surplus of money that can be used to build your net worth — the value of all your assets minus the total of all your liabilities. This involves creating a financial strategy and making sure your inflows (income) exceed your outflows (expenses).
“The question then becomes, what are you doing with your surplus? How are you saving it, how are you redirecting it? It all starts there. The goal is to increase your net worth by either increasing your assets or decreasing your liabilities, or some combination of the two,” explains Ferraro. “For example, you can deploy your surplus to a 401(k) to increase your assets, or deploy it toward student loans to decrease your liabilities. You want to be diligent with whichever method you use.”
Simply accumulating money is not the ultimate end. Money is a tool that should be used in accordance with your needs and desires. “The goal of financial planning is not necessarily making as much money as you possibly can and having it sit there,” Ferraro said further. “The goal is to one day spend it in one way shape or form. Everybody’s value system is different.”
2. Recognize your biggest asset
While it’s tempting to consider your house or bank account as your biggest asset, look no further than yourself. Considering that you likely have several decades of earnings potential, your productivity and ability to earn money that can be invested in other assets is your biggest financial asset. On average, a 25-year-old can expect to live for about 60 more years.
As Ferraro states: “People in their 20s and early 30s are their own biggest financial asset. If done right, the assets accumulated by people in their 60s exceed their future earning potential. Their assets are now worth more than their ability to earn income into the future. People in their 20s and 30s are not that way. At some point, those trajectories are going to cross if they are saving appropriately. It might be 20-30 years away, but it’s a very important concept to understand.”
Ferraro recommends protecting yourself as a financial asset, in the form of life insurance and disability insurance, especially if you have a family that relies on your income. “Think about this way, if somebody buys a house, they would never consider not insuring the value of that house. It’s too much of a financial loss if something happens to it. But most people don’t think about themselves along that line.”
3. Create an investment plan
Once you have positive cash flows and protection for your future earnings, it’s time to select an investment strategy. If you invest in stocks, which is a common choice thanks to 401(k) plans, you should keep a few things in mind.
“Unless you have an absolute conviction what the stock market is going to do, you diversify,” warns Ferraro. “Over time, diversification works as you’re going to smooth out some of the peaks and valleys. There are two types of strategies for those in their 20s or 30s: the set it and forget it approach, where you diversify yourself, continue to plug in each month. Or the active approach, which requires you to monitor your investments diligently. You need to figure out what works for you in terms of not getting emotionally wrapped up in it every day.”
Nobody cares about your financial future as much as you. The earlier you start educating yourself and creating a plan, the better off you will be.
Follow Eric on Twitter @Mr_Eric_WSCS