Millennials are routinely bombarded with the message to save for retirement. Fifty-nine percent are heeding the call and saving regularly, according to the 2016 Wells Fargo Millennial Study.
While many millennials are saving, they’re doing so cautiously. A recent Bankrate survey found that just one-third of young adults invest in the market.
[See: The Top 10 Investment Portfolio for Millennials.]
Sticking with conservative investments minimizes risk but also limits growth potential. Mutual funds offer a compromise for millennials, who are wary of individual stocks but want higher investment returns.
Diversification with minimal investment. The primary benefit mutual funds offer younger investors is better diversification for a smaller amount of money, says Katharine Perry, an associate financial consultant at Fort Pitt Capital Group in Pittsburgh.
“If you buy an individual stock, you’re only investing in that company,” Perry says. “If you buy a mutual fund that owns a hundred different companies, you get exposure to each of those companies.”
Perry says that diversifying a stock portfolio often requires a six-figure investment, but mutual funds are a way to diversify at a fraction of the cost. That’s attractive for young adults who are eager to invest but lack extensive financial resources.
Besides lower investment minimums, mutual funds also enable younger investors to diversify across a broader segment of the market.
ReKeithen Miller, a certified financial planner and portfolio manager with Palisades Hudson Financial Group in Atlanta, uses target-date funds as an example.
“Target-date funds are convenient because they allow investors to gain access to several asset classes in a single fund,” Miller says, with an initial buy-in as low as $1 in some cases.
These funds are also ideal for millennials who don’t have the time or inclination to actively manage their investments, or the budget to hire a professional advisor. Investors reap the benefits of asset class diversification and professional management in a single package, Miller says.
The benefit of time. Millennials have a long investing horizon, something mutual funds are designed for.
Rhett Wood, an investment advisor representative with Bertrand Wealth Strategies in Oklahoma City, says younger investors benefit from having more time to take risks in their portfolio. They also have a longer window to capitalize on compound interest.
“Dollar cost averaging can help you build a portfolio over time, rather than funding an account all at once,” Wood says.
According to the Investment Company Institute, the median age at which millennials buy their first mutual fund is 23, compared to 32 for younger baby boomers. The gap doesn’t seem significant but it is.
Consider this: A 23-year-old who invests $5,000 a year in a mutual fund until age 53 would accumulate more than $424,000, assuming a 6 percent annual return. A 32-year-old following the same strategy with an identical return rate would have just shy of $184,000 at age 53 by comparison.
That’s a powerful incentive to invest sooner rather than later.
Tax efficiency. Investing in mutual funds through a tax-advantaged retirement plan can yield even more benefits for millennials. A 401(k) or individual retirement account is tax-efficient by nature because investments grow tax-deferred until retirement, Perry says.
A company match through an employer’s plan augments that tax-efficient growth. If the 23-year-old from the previous example were to invest that same $5,000 per year in a 401(k) with a 50 percent employer match, those savings would grow to more than $530,000 over 30 years. A 100 percent match would notch the grand total up to more than $650,000.
Some mutual funds make more sense than others in tax-advantaged accounts.
“If you have an IRA, for example, you can take advantage of the tax status of deferred accounts by investing in actively managed funds, or less tax-efficient funds,” says Martin Schamis, vice president and head of wealth planning at Philadelphia-based Janney Montgomery Scott.
You should weigh whether a traditional or Roth IRA makes more sense. Craig Bolanos, founding partner and CEO of Wealth Management Group in Inverness, Illinois, says millennials may be better served by a Roth IRA, which allows for tax-free withdrawals of earnings after age 59.5.
[See: 10 Long-Term Investing Strategies That Work.]
“Tax-free distributions during retirement are invaluable,” Bolanos says.
A Roth also lets you access contributions at any time, without a penalty. “The gains will need to remain in the account, but you can take out what you put in,” Bolanos says.
A 2016 GoBankingRates survey found that 41 percent of younger millennials and 34 percent of older millennials have less than $1,000 in cash savings. Mutual fund investments in a Roth IRA could double as an emergency fund.
Schamis says more tax-efficient mutual funds, such as index funds and exchange-traded funds, can be held in a taxable account. Just be aware that selling mutual funds in a taxable account for a profit triggers the capital gains tax.
Many choices. With thousands of funds to choose from, finding the right ones takes some research, and cost can help winnow down the possibilities.
“The first thing any investor should look at is the expense ratio to be aware of the costs you’re paying to invest,” Schamis says.
You should also know the fund’s share class as that will affect the cost. Perry says that depending on the share class you could be paying an upfront fee or a deferred sales charge. The sales charge is based on the share class.
Your risk tolerance also will determine which mutual funds are the best fit. Although investors in their 20s will have more time to recover from market downswings, risk still matters.
Younger investors should also consider fund performance. If a fund uses a major market index such as the Standard & Poor’s 500 as a benchmark, that can help you gauge how well the fund is doing.
Perry tells millennial investors not to blindly follow the crowd when choosing funds.
Just because you hear about a fund on the news doesn’t mean it’s the best fund for you, she says, noting that “performance alone isn’t a reason to buy.”
Along with cost and performance, “look into the fund, check out the top holdings, research the fund manager and their investment style,” Perry says.
[See: 8 Investing Tips for New College Grads.]
Bottom line, make sure the fund’s objectives align with your goals before investing.
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Mutual Funds Are the Key to Millennials’ Retirement originally appeared on usnews.com
