Setting Yourself Up for Investment Success

By Hightower Great Lakes on April 5, 2022

8 Best Practices for Young Adults in the Brave New World of Investing

The investment landscape has changed markedly since you were born. Investment options have proliferated, robo-advisors have emerged and gained market share, new categories of digital assets have taken the world by storm, socially responsible investing has grown to a $40 trillion-plus market,¹ social media fuels stock market trading, and the list goes on.

While many of these changes have been positive, they also pose certain risks and can make investing your money seem even more overwhelming, particularly if you don’t have much experience. To help you navigate the brave new world of investing, below are eight best practices that may help you as you set off on the road toward becoming a sage and successful investor.

#1 Reflect and write down the purpose behind your investments

Chances are that your end investment goal isn’t simply to have as much money as possible. Instead — if you give it some thought — your ultimate goal is likely to fund specific accomplishments throughout your life. For example, perhaps you would like to purchase a home within the next five years or take a sabbatical from work to travel internationally.

Perhaps maintaining a certain lifestyle is important to you. Longer term, maybe you want to pay for your children’s education, meaningfully contribute to a social cause or retire early. While you don’t have to have every goal figured out to invest intelligently, having a sense of the size and timing of those endeavors you wish to fund can help you identify the investment strategies best suited to pay for them.

#2 Maximize contributions to a tax-deferred account

As a young adult, you have an incredibly valuable asset: time. The more time you have, the more you can benefit from compounding returns — the increased value of your savings and investment accounts derived from reinvesting interest and dividends, which are not taxed in qualified retirement accounts. To maximize this benefit:

• Take advantage as soon as possible of tax-advantaged accounts, including 401(k)s and Individual Retirement Accounts (IRAs).
• If possible, set automatic deductions from your paycheck to your retirement accounts.
• If your employer offers a 401(k) plan with a matching contribution, at a minimum contribute enough from your paycheck to receive the maximum employer match.
• Ideally, increase the amount you contribute each year as you make more money — while making sure you have enough liquidity to fund your lifestyle expenses and maintain a rainy-day fund — up to the maximum annual amount allowed under IRS rules.
• If offered, take advantage of any advice services offered through your 401(k) plan to help you select investments.

In addition to benefiting from compounding tax-free returns, by contributing to tax-deferred accounts you may also benefit from reducing your taxable income.

#3 Diversify — even if it’s not in style

While it may sound boring, combining investments that behave differently from each other under the same market conditions can lead to better risk-adjusted returns over time. Harry Markowitz proved it more than 60 years ago when he developed modern portfolio theory, and markets have continued to demonstrate the power of diversification ever since.² The key, however, is to identify truly diversifying sources of return.

Many investors build a portfolio that looks well diversified but consists of underlying holdings that are highly correlated, particularly during times of market stress. For example, investors that hold a large number of U.S. stocks often believe that they are well diversified; however, in reality, one risk will dominate their portfolio: market risk.

Bonds, smaller-cap stocks and investments linked to natural resources/ commodities are just a few examples of the types of investments that may offer additional diversification to such portfolios, being driven by other risk factors too. To identify diversifying sources of return, seek advice from an advisor who has the necessary tools to measure the underlying drivers of return and correlation.

#4 Don’t put all your eggs in the cryptocurrency basket

Speaking of diversification, cryptocurrency counts. While we have all heard of the quick fortunes that have been made by investing life savings into Bitcoin and other cryptocurrencies, the inherent long-term value of the category remains under hot debate. And the risks remain very high: Bitcoin, for example, has crashed 80% or more five times since its inception in 2009.³

That said, investing a small portion of your assets in cryptocurrency may be appropriate if you have the right risk tolerance and can financially withstand periods of significant losses. While the advice around cryptocurrency ranges dramatically, common wisdom seems to suggest that an allocation between 1% to 5% of one’s investable assets — at most — is the prudent way to invest in this exciting yet highly speculative part of the market.⁴

#5 Take taxes and fees into consideration

It’s tempting to chase high returns, but they often don’t reflect the full picture. The reality is that you can only consume investment returns that are net of taxes and fees. You also need to be mindful of various tax rules around investing and trading, including wash sale rules, an Internal Revenue Service (IRS) regulation that prohibits someone from claiming a loss by selling and purchasing the same or similar securities within 30 days before or after the loss.

To understand the importance of this point, consider one extreme example of an individual who took up day trading and reportedly owed $800,000 in taxes on $45,000 in net trading profits,⁵ largely due to the individual running afoul of wash sale rules. Or in a much less extreme example illustrating the impact of fees, consider a simple example provided by Vanguard. Imagine you have $100,000 invested.

If the account earned 6% a year for the next 25 years and had no costs or fees, you’d end up with about $430,000. If, on the other hand, you paid 2% a year in costs, after 25 years you’d have only about $260,000.⁶ However, the point is not to look for investments that won’t generate any taxes or fees. Investing comes with costs. The takeaway is to understand these costs and factor them into your decision-making.

#6 Avoid stock picking

Be wary of stories you read in the news or hear from your friends about easy profits to be made from day trading stocks. While the rise of online brokers, such as Robinhood, make trading easier, it has also contributed to herd mentality (investors’ tendency to follow what other investors are doing rather than what is best for themselves) with negative consequences.

A recent analysis from the Journal of Finance illustrates this point. Researchers found that the top 0.5% of stocks bought by Robinhood users each day experience negative average returns of approximately 5% over the next month and that more extreme herding events are followed by negative average returns of almost 20%.⁷

Also, keep in mind that beating the market — achieving returns greater than what could be achieved from simply investing your money in broad market index funds — is difficult to do, even for the most sophisticated, highest-paid investment professionals. This means having humility, recognizing your limitations and seeking professional advice are important steps toward investment success.

#7 Know thyself — recognize behavioral biases

Self-awareness is also a virtue in investing. Although many of the economic theories you may have learned in college assume rational behavior, the field of behavioral economics has come to identify an array of human tendencies that can negatively impact investment results. In addition to herd mentality, examples include: Recency bias: The tendency to overweight the importance of recent observations.

This can lead to chasing high returns in hot stocks and investment fads based on recent performance rather than long-term fundamentals. Loss aversion: Being more upset with losses than pleased with gains. This bias can result in misalignment between your investments and the amount of risk you need to take to achieve your long-term goals. It can also lead to costly attempts to time the market to avoid losses.

Endowment bias: The propensity to place more value on assets already owned. This can cause investors to hold on to investments even if they don’t align with their risk tolerance or investment goals. Familiarity bias: The tendency to favor the familiar. In investing, a common manifestation of this tendency is home bias, or the preference to own stocks or other investments originating from one’s home country — even though an allocation to global investments may offer better diversification.

The above are only a few of the behavioral biases that can negatively impact your investment decisions. For further education, and to help recognize these types of biases as they creep into your investment decisions, read more about behavioral finance.

#8 Lean on a financial advisor

You may be skeptical about the financial industry or advice from a human in the digital age, where information is abundantly free, algorithms reign and real fortunes are seemingly made in meme stocks. But while digital tools may offer value as part of your investment approach, they are not a substitute for relationship-based advice.

A financial advisor can help you manage your entire financial picture (e.g., instead of just picking investments) and provide answers relevant specifically to you. They can save you significant time, money and stress and will be more vested in your investment results than the latest fintech app.

Just because you are young does not mean you can’t be wise. By following the above guidelines, you can avoid investing mistakes commonly made by older generations. You can also tune out noise and speculation while remaining focused on achieving what matters most to you. If you need help, please reach out to us, and we can connect you with the right resources.

If you’re interested in discussing your investment strategy or know a young person that could benefit from financial advice, contact Justin McCurdy, CFP® at jmccurdy@hightoweradvisors.com or (219) 476-3035.

Hightower Advisors, LLC is an SEC registered investment advisor. Securities are offered through Hightower Securities, LLC member FINRA and SIPC. Hightower Advisors, LLC or any of its affiliates do not provide tax or legal advice. This material is not intended or written to provide and should not be relied upon or used as a substitute for tax or legal advice. Information contained herein does not consider an individual’s or entity’s specific circumstances or applicable governing law, which may vary from jurisdiction to jurisdiction and be subject to change. Clients are urged to consult their tax or legal advisor for related questions.