Millennial Money

How Young Investors Can Build a Fortune

Palgrave Macmillan

Contents

THE MILLENNIAL EDGE

In 2060, lifelong friends Liam and Grace are attending their fiftieth high school reunion and reminiscing about their lives. In their 68 years, they have seen the world transformed. They watched astronauts land on and colonize Mars, saw President Pierce inaugurated as the first leader of the Global Confederate States, and marveled as the robot population surpassed the human population. They also remembered tumultuous times. Both Liam and Grace had aggressive cancers in their 60s, but survived thanks to organ replacement therapy. They also lived through the student loan crisis of 2018, the Global Depression of the 2030s, the bioengineering and robotics stock bubble of 2041, and the plutonium and uranium crisis of 2050.

They both enjoyed successful careers and earned similar incomes during their working lives; Grace worked as a publisher and Liam worked in sales. Yet their lives in 2060 are very different. Grace now splits her time between New York City, Montana, and Tuscany; travels twice a year with her grandchildren; and is the chief benefactor of the Botswana Preservation Initiative. Liam lives with his son and daughter-in-law in Delaware, in a house that he helped them buy with some of his savings. He'd always wanted to retire in Oregon but, with the depletion of Social Security (the fund ran out in 2035), he had to abandon his dream and accept his son's support.

Liam and Grace's later years were so different because they took very different approaches to saving and investing. Liam, like many of his millennial contemporaries, didn't start saving in earnest until he was 40, and when he did save, he was very conservative with his money. Because he had watched his parents lose their house and go through bankruptcy, and seen his grandmother's stock portfolio decimated in the crash of 2007–2009, he was very averse to risky investments. He avoided stocks and instead built up his savings account. Because he had all his money in savings and bonds, he easily weathered the market crash of 2031, when a Global Depression hit and dragged the stock market down 75 percent. Liam thought his plan was safe and responsible, but come retirement, the purchasing power of his savings — what he could afford to buy — had eroded. He had saved more than $2,000,000, but it wasn't enough to live on comfortably. The modest apartment he hoped to buy would have cost $300,000 in 2014, but now, in 2060, cost $1,750,000.

Grace took a much different approach. She started investing once she was earning her first steady salary at age 22, taking a small amount from each paycheck and investing it in the global stock market. She continued to make investments throughout her life, even after three severe market crashes that each temporarily crippled her portfolio. After the crash of '31, she invested every spare dime she had in the market. She realized early in her career that youth trumps everything in investing, and that stocks are the only logical investment for young investors. Her choices were aggressive, and she built a sizable nest egg by the time she was 50 and a small fortune by the time she was 60.

The large ultimate divergence in lifestyle between these old friends started with two simple decisions early in their lives: when to start investing and what to buy. The choices you make today — and in the years to come — will determine whether you live like Liam or live like Grace. This chapter explains why Grace succeeded and Liam failed. Grace's secret was investing young and putting all her money into the global stock market. Liam's error was starting later and thinking that savings and conservative investments were safe when they were instead dangerous. As we shall see, fortune favors the young.

The Millennial Investor

Liam and Grace are two members of the huge millennial generation. Defined as those born between 1980 and 2000, millennials make up the largest generation in history — there are 80 million of us in the United States alone. More than half of millennials have already entered the workforce, and more than 10,000 of us turn 21 every day. Unfortunately, because of the tough times that we have already lived through and the unique challenges that we will face in the future, it will be easy to fall into the same traps as Liam. Like Liam, many of us have grown up watching the stock and housing markets crash, often bringing devastation and even financial ruin to those we love. Student loans hang over our heads and good jobs are still scarce.

The tough environment in which we've grown up has had a huge impact on our investing preferences. In a 2014 survey — which compared investing preferences across generations — millennials reported a risk tolerance about as low as those in the World War II generation. We may be young and have the highest ability to take risks of any generation, but we are as conservative as our grandparents. In the survey, both baby boomers and Gen Xers had a higher risk tolerance than millennials. The survey report says, Millennials are the most worried of all generations. But unlike what might be expected, their concerns are very long-term in nature — retirement and their own long-term care — issues that are decades away. They are also worried about their financial situations and avoiding making financial mistakes." Millennials responding to the survey were so conservative that, on average, they had 52 percent of their portfolio in cash. Even millennials with tons of money — $100,000 or more — had a 42 percent allocation to cash. Non-millennials, by contrast, had a 23 percent average allocation to cash — a much more appropriate number. As the survey report says of our high cash position, Clearly this allocation is not just based on cash needs, but reflects wariness about financial markets." This entire profile of the millennial investor should sound familiar: this is Liam's attitude writ large. In the spirit of Liam's conservative approach, millennials in the survey only had 28 percent allocated to stocks, while older generations had an average of 46 percent allocated to stocks. This is a vexing contradiction, because to end up like Grace we need to own more stocks and less cash. Cash may seem safe, but as we shall see it is risky in the long run.

The good news is that young people today have more investing advantages than any group in history. Youth itself is our most important advantage, but never before have young people had such easy, cheap, and diverse access to global markets. Thanks to innovation and competition in finance, you can now buy anything you want with the click of a button. From domestic stocks, emerging market stocks, bonds, and real estate to commodities like gold, silver, palladium, wheat, corn, and livestock (and the list goes on), a huge range of investments is available to us, all for a low fee. The variety of choices can be daunting, but the simplest choices still work the best. Before explaining why stocks are the key to wealth, we must first understand why youth is such a formidable investing advantage.

Compound Returns: The Great Money Multiplier

When I was seven years old and in first grade, before realizing how destructive it could be to my playground reputation, I played competitive chess. With time to kill between tournament games, my dad would often tell me the story of the chess master and the emperor. The story went that the inventor of chess was showing the new game to his emperor and the emperor was so impressed that he offered the man any reward that he desired. The man's clever request was that the emperor place one piece of rice on the first square of the chessboard, two on the second, four on the third, and so on, doubling the rice grains until all 64 squares were filled. Trying to teach me a lesson, my dad would then give me two choices for a reward of my own: I could do the same chessboard doubling with pennies instead of rice grains, or have one million dollars. At the time, I was only able to double numbers up to 32 or 64, and much more concerned with when I was going to be able to play Mortal Kombat again than with his damn riddles, so I chose the million bucks. Well, when my father explained that if I'd chosen the doubling pennies I would have had $10 million by the 31st square and $92 quadrillion by the 64th, I felt pretty dumb.

This was my first lesson in the miracle of compounding, a very simple, but very powerful, bit of math. Compounding is so important for young people because each year of our lives is like a square on the chessboard — and we have a lot of spaces left ahead of us. Compounding is the engine that will make our stock portfolios grow, and time is the fuel. The key to compounding returns is that they have a much larger influence on our fortunes later in life than they do early on. Even if the percentage gains that we earn stay the same every year, the dollar gains will be much larger in later years. The doubling pennies in Table 1.1 reveal why. It takes fifteen chessboard squares to pass $100, but in the next fifteen squares the fortune grows from $163.84 to $5.4 million. Again think of each square as a year of your life. In the early squares — which represent our 20s and 30s — the dollar gains are small. But in the later squares — our 50s and 60s — the same doubling results in massive dollar gains with each new square.

Your stock investments won't ever double in value in one year, but even at much lower annual growth rates, compounding is still a powerful force. Because the magic happens later on, the year you start investing has a huge influence on where you end up. Imagine that you and two friends all make investments in the stock market at various points in your careers and all earn the same 7 percent annual return, after inflation, that stocks have delivered across history. You start investing $10,000 per year in the stock market at age 22 and your two friends invest the same amount, but one starts at age 30 and the other at age 40. Once they start investing, each makes the same annual $10,000 investment and earns the same 7 percent annual return. The only difference is time spent in the market. If you started at 22, you'd have a portfolio worth $4.7 million when you're 65. Your friend who started at age 30 would have $2.5 million, and your friend who started at 40 would have $1 million. Think of the difference in lifestyle that extra $3.7 million could buy you.

Other than time, the only other variables that could have made a difference to these hypothetical investors are the annual investment amount and the annual return. But neither higher returns nor larger investments can make up for lost time. If the 40-year-old investor somehow managed 10 percent annual returns instead of 7 percent — an enormous improvement — he'd still only finish with $1.8 million, less than half of the total you'd have earned by starting very young. If the 40-year-old investor made $20,000 annual investments instead of $10,000 investments, he'd end up with $2 million — a significant improvement from $1 million, but still well short of $4.7 million. As this example makes clear, each year is precious and there is no substitute for time. Even if you are in your 30s or 40s and haven't started investing, you should start investing now. As the Turkish proverb says, No matter how far you have gone on the wrong road, turn back." Grace captured youth's potential, and you should too.

The Importance of Real Returns

Liam didn't fail because he was too conservative; he failed because the options that he thought were safe (his savings account and bonds) were in fact dangerous long-term investments. Savings and bonds are dangerous for millennial investors because we are the first complete generation born into a world where the value of our money has no anchor. Without an anchor, the value of each dollar (and any cash that you hold) deteriorates over time as our governments print more money. This is a relatively new problem, because from America's founding until the 1970s, dollars did have an anchor: each dollar was defined as some weight in gold or silver. In our lifetimes, dollars have never been fixed to anything concrete. When dollars have no anchor, inflation is a silent killer. Even in my lifetime, inflation has ruined the value of a dollar; a car that cost $10,000 when I was born in April 1985 would cost more than double that ($22,000) in 2014. Dollar devaluation is a key variable pertaining to Liam and Grace's second important decision: what to buy.

Compounding works best if you earn strong annual returns, so the next question is: where should you invest? When evaluating investment options, we have to consider returns that we can earn after inflation. Here's why. Let's say one month you spend $1,000 buying groceries, paying rent, and buying some new clothes. You also invest $1,000 in the stock market. Twelve months later, your portfolio has jumped to $1,100 — a solid 10 percent nominal" return. But when you go to run the same errands and pay your rent, it now costs you $1,100, $100 more than last year. In this example, inflation has destroyed your nominal return. Your real," after-inflation return is 0 percent. While your portfolio's dollar value rose by $100, your purchasing power did not change at all. Real returns are all that matter.

Inflation is a threat for millennial investors because we live under a fiat money system; fiat is Latin for let it be done." Under a fiat money system, money is printed" or created by governments, and when more money is printed, inflation tends to rise. For most of history, money was tied to something physical and tangible like gold or silver. The modern dollar is instead an abstraction, created out of thin air. If the government continues to create billions of new dollars — thereby increasing the supply of money — then prices (inflation) will continue to drift upward over time. These price increases are a huge drag on our returns.

Millennials have always lived under a fiat system, but even so it is a fairly recent development. At various points in history, money has taken the form of paper, coins, gold, silver, salt, cattle, deerskins, vodka, ivory, wampum beads, and sperm whale's teeth. The first coins appeared in the kingdoms of Lydia and Ionia around 640 BCE. These coins were made of electrum — a naturally occurring alloy of gold and silver from a nearby river where King Midas is said to have bathed. The Incas called gold and silver sweat of the sun" and tears of the moon," and gold and silver have been used as money ever since. They worked so well because there is a limited supply of gold and silver in the world. Because we can't create more, each ounce of gold retains its value well. Limited quantities mean stable values and low inflation.

The history of money in the United States also began with gold and silver. At its birth in the Coinage Act of 1792, the US dollar was fixed to the price of gold and silver, meaning you could exchange one dollar for 371.25 grains of silver or 24.75 grains of gold. The key advantage of a gold standard is that it acts as a check on our government's ability to create more money. More money introduced into circulation makes every dollar worth less (inflation), in that each dollar can be used to buy fewer goods and services. Figure 1.1 shows the price of an ounce of gold in US dollars since the original Coinage Act of 1792. Though the price was mostly steady for almost 200 years, there were occasions when the dollar was devalued relative to gold. The first disruption, which appears now as just a tiny blip, was the result of President Lincoln and the Union issuing $450 million dollars in paper notes known as greenbacks" to pay for the northern army in the Civil War. The greenbacks were an early example of fiat money.

Despite brief interruptions like the Civil War and Great Depression, the gold standard lasted a long time. We even affirmed a gold standard as recently as 1944 when representatives from 44 countries met in New Hampshire to outline the post–World War II global economic landscape. In their resulting Bretton Woods Agreement, the US dollar was fixed at $35 per gold ounce. But in the early 1970s, the US economy was weak, the bill for the Vietnam War was mounting, and our government's annual spending burden had risen significantly thanks to new entitlement programs like Medicare. The government wasn't collecting enough tax money to cover all these rising expenditures, so President Nixon and his key advisers decided that the United States must end its gold standard so that it could print money at will. Nixon's decision, known as the Nixon Shock," permanently moved the United States to a system of fiat money. In the ensuing decade, the value of the dollar plummeted against gold. At the end of 1970, an ounce of gold cost $37.60, but ten years later, in 1980, that same ounce cost $641.20 — a 17-fold increase. Gold now represents but a small fraction of the money in circulation. As of July 2013, the United States holds roughly $381 billion worth of gold. That may sound like a lot, but there are more than 10 trillion US dollars in circulation. That means only 3.5 percent of our money is backed by gold.