Millennials just got hit with a double dose of bad news.
A new study says that barely half of 30-year-olds enjoy higher earnings than their parents did at the same age. Another report predicts that millennials won’t live as long.. At this rate, millennials will have less time to spend whatever they can manage to save.
Blocking their path are what I call the four enemies of the investor: bear markets; inflation; taxes, and emotions (BITE). Here are four ways millennials can combat these adversaries:
1. Bear markets: This is perhaps the toughest enemy to avoid, because the onset of a bear market is beyond the control of investors. Typically, a bear market occurs when there is at least a 20% decline in broad-market index prices over a period of two months or more. Market correction is the term used when prices decline at a rate of 10% or more during a shorter time frame. A market correction can kick off of a bear market, which can be quite painful and lead to emotional decisions.
Because many millennials came of investing age during the market crashes of 2000 and 2008, they are somewhat hesitant to invest in stocks. This is usually not to their advantage as the U.S. stock market, over long periods of time, has almost always outperformed cash and bonds. Studies show many millennials are skeptical of stocks (much like how depression-era children doubted the stock market).
Solution: Given their age and time horizon, investing in stocks presents one of the best opportunities for younger investors to outpace inflation and have the purchasing power to enjoy retirement. One tip for millennials is to expect that stocks will decline. They should also realize that the cost of investing in stocks is the market volatility, while the cost of not investing in stocks is usually a lower long-term portfolio return.
2. Inflation: Inflation is the general increase in prices and fall in the purchasing value of money. Because millennials have more years before they will use their accumulated savings to pay their bills, inflation impacts their saving goals more than those nearing retirement.
This is where the conundrum lies: For an investor to have the best chance of earning more than inflation over time, they need to take on risk. But millennials have been cautious to embrace stock market risk because they witnessed the decade of the 2000’s when the S&P 500 SPX, +0.13% produced a negative return.
Solution: Instead, they may choose relatively lower-risk (cash and bond) investments, which may pay a rate of interest less than the inflation rate. Earning less than the inflation rate is known as a negative real rate of return, which represents a decline in purchasing power.
Cash, for example, may feel safe when it avoids losses and earns, for example, a rate of 1%; but if inflation is about 2%, then you are effectively losing money. If this happens year after year, you will decrease your chances of reaching your long-term goals. This is why it is important to take on as much risk as you are comfortable with.
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3. Taxes: Taxes affect all investors, and with our nation’s growing deficit, taxes may prove to be more onerous for success-minded millennials than earlier generations.
In a post-pension world, the vast majority of younger workers have the challenge of self-funding their retirement. After decades of slow wage growth and an economy that is still recovering from the 2008 economic crash, millions of college graduates are saddled with large amounts of student debt and not a lot of cash to invest.
As I noted earlier, many millennials avoid the risk of the stock market for what they perceive to be safer savings vehicles. By doing so, they are exposing themselves not only to lower potential rates of return, but also to higher tax rates. This is because investments such as CDs, money markets, and corporate and U.S. Treasury bonds are taxed at ordinary income tax rates. With today’s relatively low interest rates, it is often difficult to earn more than the inflation rate, especially after taxes.
Solution: For investors who can handle riskier investments and have a longer-term focus, the more favorable, long-term capital-gains tax rate is currently at a maximum 20%. However, these gains may also be subject to state and local income taxes and the 3.8% tax in the Patient Protection and Affordable Care Act. The bottom line is that taxes reduce the growth you have in your account and make self-funding retirement more difficult.
One way to avoid the annual tax hit is to set aside money on a pre-tax basis in a 401(k) plan and let it grow tax deferred. However, in retirement, every dollar withdrawn from 401(k) plans will be taxed as ordinary income. With state governments trying to balance their budgets, and with the growing federal deficit, it is unlikely that tax rates in retirement will be significantly lower for those who have adequately saved for their future financial independence.
Investing tax-efficiently as you accumulate for retirement can help, but there are few exceptions to the tax hammer. If you qualify, a Roth IRA can be advantageous, and growth inside a life insurance policy or from certain municipal bonds may escape the tax man.
4. Emotions: Emotional reactions to market gyrations can hurt your investment portfolio’s return. Intellectually, it’s easy to understand that markets rise and fall. However, when you see your savings disappear, the emotional tendency may be to pull out of the market. The risk is that, if you don’t get back into the market in advance of the next rebound, you may suffer a “permanent impairment of capital,” and that is when the mistake becomes real.
Solution: Know your risk tolerance. Then, build a well-rounded, diversified portfolio that you can live with in bull and bear markets. This can help keep your response to an inevitable decline less reactionary and more rational. Keep in mind that neither diversification nor asset allocation can guarantee against a loss; these are methods used to manage, not eliminate, risk.
Mark Avallone is president and founder of Potomac Wealth Advisors, LLC, and author of “Countdown To Financial Freedom: Your Path to a More Meaningful, Active, and Vibrant Retirement.”