Have you heard the stock market mentioned in the news lately? Or maybe you’ve scrolled through social media and witnessed someone touting their ginormous investing gains. Perhaps you have even opened an online brokerage account and dabbled in the stock market a bit yourself.
Whatever the case may be, there is a reason for all the buzz—the stock market is one of the world’s most powerful wealth-building machines.
The good news: access to the stock market is open to nearly everyone…even teenagers. The bad news: it is very easy to lose money in the stock market if you do not know what you’re doing.
But HOLD UP. Don’t get the wrong impression. You don’t need to be an expert or genius, and you definitely don’t need to have a Ph.D., bachelor’s degree, or even a high school diploma to begin investing successfully…the stock market is for everyone. You just need to do a bit of light reading before you start. This article is a great first step. Let’s dig in!
Why Should You Start Investing for Retirement when You are Young?
Let’s look at some numbers.
$2,958,497—that is the potential value of your investment account at sixty years old, if you begin saving at age twenty. Starting at age eighteen? Try $3,572,864. Age fifteen? $4,736,482. How is this possible? The answer is putting $6,000 into a savings account each year and allowing your money to grow at a rate that matches the average performance of the stock market.
Okay, pump the brakes. Why would your money grow in the stock market? Well, on average, the stock market has always gone up over time, and most experts seem to think it will continue (though not without the usual ups and downs along the way). Throughout this article, all hypothetical account growth scenarios assume 9.7% annual growth, which is what the broader stock market has averaged since the early 1900s.
Take a special look at the difference in account balances when starting at age fifteen versus starting at age twenty—$1,777,985. A five-year delay in saving a total of $30,000 ($6,000 per year) can cost you a whopping $1.8 million at retirement.
You may be thinking that this sounds fine and dandy, but you’re a teenager, which means that A) you probably don’t have an extra $6,000 laying around each year, and B) there are more important things that you need to spend your money on…like that new $30,000 car you’ve been wanting.
Try thinking of it as a tradeoff—spend your $30,000 now or spend your future $1.8 million later.
Realistic Investing Scenarios for a Teenager
The purpose of the numbers above was to wow you…to prove a point on the importance of starting your investing journey as soon as possible. If you can put $6,000 or more into the stock market every year, awesome. But for the average teen, here are some more realistic investing scenarios.
If you start at age twenty, you only need to invest $173 per month to have $1 million in your account by retirement at age sixty. Not too bad, right?
If you begin investing at eighteen, you will need to put in only $142 per month to retire a millionaire.
And if you begin at fifteen, a measly $106 is all that is needed. This is very doable.
The average American waits until they are thirty-one years old to begin saving for retirement…which means they will need to invest $522 per month to have a shot at retiring a millionaire. Better late than never, I guess? But unfortunately, these people have given up an entire decade of investing help from the world’s most powerful force—compounding.
If your money is invested in the stock market, it will experience compounding growth. When compounding, your money makes you money, and then that extra money makes you even more money, and then that money makes money, which makes money, which makes more money, and this goes on and on and on—it is an exponential increase!
For example, the 10% annual compounded growth of an initial $1,000 investment would look like this:
Year 0 (starting amount) = $1,000
Year 1: $1,000 + ($1,000 x 10%) = $1,100
Year 2: $1,100 + ($1,100 x 10%) = $1,210
Year 3: $1,210 + ($1,210 x 10%) = $1,331
Year 4: $1,331 + ($1,331 x 10%) = $1,464
Year 5: $1,464 + ($1,464 x 10%) = $1,611
You’ll notice that the account balance does not just increase by $100 (10% of the initial $1,000) each year. Instead, with compounding, the yearly 10% increase continues to lift the prior growth as well. This phenomenon intensifies over time. Here is a fast forward of the above example to show future year-end balances:
Year 10: $2,594
Year 20: $6,728
Year 40: $45,259
The most noticeable growth in a set of compounding numbers is always going to be at the very end of the timeline—it’s in the math! This is why you want to start compounding your money as soon as possible.
Of course, the percentage increase (a.k.a. “rate”) matters, too. If you have a regular savings account at a bank, you are likely being paid interest every month; this money is also experiencing compounding. However, the interest rate paid by banks has historically been much less than the average 9.7% annual growth of the stock market.
Stock Market Basics
To raise money, businesses sell fractions of themselves to the public—known as shares of stock. A share of stock represents a “piece of the pie” of a whole company, and the stock market is a venue for trading these shares of stock. Well-known stock markets include the New York Stock Exchange (NYSE), National Association of Securities Dealers Automated Quotations (NASDAQ), and London Stock Exchange (LSE).
To buy a portion, or share, of a company, there must be another person on the other side of the transaction to sell it to you. Likewise, to sell a share of stock, someone must be willing to buy it. When there are more “buyers” than “sellers,” the stock price rises—the simple law of supply and demand. People are willing to pay more and more for ownership of the company (usually because they believe it will increase in value). And vice versa—when there are more “sellers” than “buyers,” the stock price drops.
How Stocks Can Make You Money
Now, there are two primary ways that being a shareholder (stock owner) can pay off:
- An increase in the price of the stock
- Income generated by dividend payments
As the value of a company rises, the price of the stock you own increases, and at some point, you will (hopefully) be able to sell your shares for more money than you paid to purchase them.
A dividend is a corporation’s payment to shareholders just for existing. Dividend payments are quarterly payouts (every three months) of a company’s earnings deposited straight into your account. The more shares you hold, the more dividends you will receive. Larger, more stable corporations are the most frequent issuers of dividend payments and often increase their dividend payments annually.
Risk vs. Reward When Investing
The stock market is not always rosy. Risk is involved with all investments, and out of all the available types, stocks are considered on the riskier side. You could technically lose all your invested money if a company goes bankrupt, and many past investors have. Still, there are ways to mitigate this risk.
Most experts will actually encourage you to have a healthy amount of risk in your investment portfolio—especially for investors on the younger side—because as your “risk” increases, your potential “reward” increases as well. It is also commonly recommended that people have an investment strategy that naturally reduces risk when approaching retirement by spreading their collection of investments across stocks, bonds, cash, real estate investment trusts (REITs), etc. This is called asset diversification.
However, a young person can ride the ups and downs of the stock market easier than someone five years from retirement. For young investors, taking on extra risk now will likely result in greater rewards in the long run. This is referred to as taking on a more “aggressive” investment strategy. It is also why this article focuses on stock market investing for teens.
Your Stock Gains Will be Taxed…Usually
Up to this point in your life, you have not had to think about taxes very much. If only that could continue! When you sell stocks for a profit, you incur a “capital gains” tax, which the government collects. However, there is a way to avoid losing your hard-invested dollars to taxes if you save and invest through the correct account type.
For readers in the US, there is some good news—Uncle Sam has your back. Americans have issues saving and investing for retirement, and many people find themselves working late into life because they cannot afford to stop getting a paycheck. To help combat this, the US government passed the Taxpayer Relief Act of 1997 and established what is known as a Roth Individual Retirement Account (Roth IRA).
The Federal Government’s Gift to You—the Roth IRA
A Roth IRA allows you to add a certain amount of money to an account each year, and then when you eventually retire, you do not have to pay taxes on any of the money you take out (which is a big deal). The initial money you deposit inside the Roth is called a “contribution,” and you can transfer contributions directly from your primary bank account as often as you like.
As a Roth IRA account owner, you are exempt from paying capital gains taxes at disbursement (retirement, beginning at age 59 ½). The contributions to your account will be added only after you pay income taxes on them (a.k.a. “after-tax contributions”). In other words, you get the taxes out of the way now to reap the rewards of your compounded investments later. Once in your account and invested in the market, your money can compound for 10, 20, or 30+ years, tax-free. Wouldn’t you prefer to pay your tax rate on a small number of dollars now rather than the millions you will have later?
Roth IRA Qualifications and Requirements
The specific rules applied to Roth IRAs have changed over time. Check irs.gov to get the latest, but here are some account requirements to consider:
- The maximum annual contribution limit for a Roth IRA (as of this writing) is $6,000. You are not allowed to deposit more than the maximum limit into your account, for a given tax year. This number is usually adjusted up over time to account for inflation.
- There is a maximum income limit, over which you must phase out of Roth IRA contributions. As of this writing, you cannot earn more than $143,000 per year and still deposit money into a Roth IRA. This requirement is not difficult to meet for most teenagers!
- If you withdraw contributions before age 59 ½, you pay no tax or penalty. However, withdrawing earnings before age 59 ½ can mean you owe income tax and a ~10% penalty.
- There is no minimum age to qualify for a Roth IRA.
- The money deposited into a Roth IRA must be earned income.
Ah, see, there it is. That last one is the sore point. You must have a job and earn income to qualify for a Roth IRA account…birthday gifts from grandma don’t count. Check out Earning Money for Teens for ideas!
The Traditional IRA
We can’t talk about Roth IRAs without mentioning their sibling, the Traditional IRA. While a Roth IRA allows for after-tax contributions, a Traditional IRA allows for pre-tax contributions. This means that whatever money you put into a Traditional IRA, you can usually deduct from your income taxes for that year; however, unlike the Roth, you must pay taxes on all withdrawals once you retire, as it is treated as income. In summary, a Roth IRA allows you to enjoy more money in the future, while a Traditional IRA allows you to enjoy more money today.
It is widely accepted that a Roth IRA is the way to go if you will be in a higher tax bracket once you retire and begin to take withdrawals. As a teenager, you fit the bill for this description (you will likely get raises throughout your working career, thus placing you in a higher income tax bracket at retirement).
You may not have a 401(k), but the adults in your life have likely brought it up in conversation before. What is it? Well, all things considered, a retirement 401(k) is not very different from an IRA—in fact, they can also be set up either as a “Traditional” 401(k) or a “Roth” 401(k). You can contribute up to a certain amount of your earnings to it each year, invest it, and then begin taking money out at retirement. Aside from some nuanced taxation differences, the primary distinguishing attribute of a 401(k) versus an IRA is that the 401(k) is “employer-sponsored.” One day farther down the road, you may find yourself working for a company that offers an employee 401(k) retirement plan.
Which Investments are Worthy of Your Hard-Earned Money?
As touched on earlier, all investments come with risk. Risk refers to the likelihood that you will lose money on an investment. The riskier the investment, the higher the potential reward; the safer the investment, the lower the potential reward. It is a trade-off.
For example, if you want the reward of scoring a date to prom, you must pop the question and risk a lot of rejection. Likewise, if you want the reward of becoming a stock market millionaire, you have to risk losing some of your money.
Successful investors find a key balance between risk and reward—usually through the “wide net” tactic of diversification.
A properly diversified investment account is made up of stocks across all industries and of all sizes. This limits your risk while still providing plenty of upside for your money to grow. While you could always pick out and invest in many different companies, one at a time, there are two mechanisms for diversifying your portfolio without having to buy shares of each separate stock yourself: mutual funds and exchange-traded funds (ETFs).
Mutual funds are a collection of stocks that a banker on Wall Street researches and selects for you. When “retail” (nonprofessional) investors like you and me buy into a mutual fund, our cash is all pooled together. Then, the money manager selects which investments to make. The average mutual fund holds over 100 different companies, so naturally, your investment is very diversified.
ETFs are a very similar concept to mutual funds in that they represent a broader group of investments. However, unlike most mutual funds’ active management, ETFs are passively managed. ETFs are set up by the folks on Wall Street to track an underlying index (basket of stocks) based on some common criteria, but then they just leave them alone. There may be a few tweaks or rebalancing in the fund here and there, but there is very little “cherry picking” going on because they are trying to simply match the market, not outperform it. As a result, most ETF fees are lower than mutual fund fees, but they still do exist because there is some cost to operating and managing the fund.
Here are some of the most popular ETFs:
- SPDR S&P 500 (SPY): Tracks the S&P 500 Index, the 500 largest public companies in the US.
- SPDR Dow Jones Industrial Average (DIA): Tracks the thirty stocks of the Dow Jones Industrial Average, which aims to represent the American economy
- Invesco QQQ (QQQ): Tracks the Nasdaq 100, which is mostly technology stocks
- iShares Russell 2000 (IWM): Tracks the Russell 2000 small-cap index, representing 2,000 of the smallest public companies in the US.
What is an Index?
You may have noticed the word “index” listed in the names of some of these ETFs. An index shows the hypothetical performance of a chosen basket of stocks—usually the broader market in some fashion. An “index fund” is an actual legal entity designed to track an index, and these funds can be structured as mutual funds or ETFs.
Look for These Items When Research Mutual Funds and ETFs
When you are researching mutual funds and/or ETFs to decide what to invest in, remember to look for these big three items, which will all be clearly stated on any fund summary page:
- Historical Performance (what has been the average annual return of the fund over the past 5, 10, 15+ years?)
- Expense Ratio (what percentage of your money will be lost to fees each year?)
- Diversification (what variety of companies is built into the fund?)
Mutual funds and ETFs are great investment vehicles for beginners (and frankly for investors of all ages) because they track the returns of the stock market and limit risk by building in diversification.
How to Start Investing in the Stock Market
There are many online platforms to choose from when you open your account, called “brokerages.” A broker is a matchmaker for investors—they bring together buyers and sellers and facilitate the trade between the two. A brokerage account allows you to buy and sell your investments. Sample platforms as of this writing include E*TRADE, Fidelity, Vanguard, and Charles Schwab. Make sure the brokerage you are using carries Roth IRAs! Some do not.
Also, when researching brokerages to determine the route you want to take, make sure to compare commissions (fees for buying or selling stock, which are usually charged as a flat rate per order). Many brokerages are moving to a commission-free model for stocks and ETFs.
Open Your Investment Account
Once you select a broker, you’ll need to set up your account. The exact details may differ, but the general flow of the application should look something like this:
- Select your account type (Roth IRA will likely be listed with the retirement accounts)
- Input your personal information
- Verify your identity (Your Social Security number will be required; if you are under 18, you can open a “custodial” account, which means you will need a parent’s or guardian’s information here)
- Create a strong, unique account password
- Name your beneficiaries (list who should receive your money if you have an untimely death)
- List your investing goals if prompted (long-term vs. short-term, aggressive vs. conservative strategy, etc.)
- Link your checking/savings account and transfer in some money
Setup Recurring Contributions and Dividend Reinvestment
If you have a steady source of income, consider setting up recurring contributions. Your brokerage will then automatically draft your bank account every month (or every two weeks, etc.) on the dates you select. For example, if you want to contribute a total of $2,400 for the year, then set up a monthly contribution of $200 ($200 x 12 months = $2,400 total).
Also, consider activating your brokerage’s “dividend reinvestment” option. Enrolling in a Dividend Reinvestment Plan (DRIP) will automatically take your dividend disbursements and invest them commission-free into additional shares of the same stock (often buying partial shares of the stock). Instead of letting that cash sit idle in your account, why not just reinvest it? More compounding!
Place an Order to Purchase Shares
Once you transfer money into your new account, don’t forget to actually invest it! Otherwise, it will just sit as cash in your account.
If you are putting money into a mutual fund, simply search for the fund you want, click “Buy,” and input your desired investment amount, and then click “Place order.” It is really that simple.
If you are placing an order for an ETF, search for the ETF name and pull up its summary page. Click “Buy” to take you to the order form. Here, you will see the “Last Price” listed, which is the price per share. Calculate and input the “Quantity” of shares you wish to purchase. If your broker does not offer fractional trading (the ability to buy portions of a share), you will need to round up or down to the nearest whole number of shares.
Next, you will need to select a “Price Type” (or “Order Type”), which will let your broker know what price you are willing to pay for the ETF shares. Do not be intimidated by the different options you see, which will probably include options such as “Market,” “Market on close,” “Limit,” “Stop on quote,” and “Stop limit on quote.” The most commonly used option here is “Market,” which is all you will likely ever need to select.
Once your price type is selected, you will likely need to specify a “Duration” for the order, which will tell your broker how long you want it to remain in effect until fully executed or canceled.
Click “Place order” and watch it go through! If it is the weekend or after market hours, you’ll have to wait for it to execute once the market reopens.
Start Investing for Retirement ASAP – Your Future Self Will Thank You
In summary, delayed gratification and early investing can impact the second half of your life even more so than whatever university you get into, the degree you seek there, and the job you get afterward. This stuff is unfortunately not taught in most schools. Actions to take are:
- Open a retirement account and regularly add money to it.
- Use that money to invest in the stock market and generate compounded returns.
- Do not take out any money until you retire.
Time is of the essence. If you wait to start saving until after you graduate, after you find a job, after you pay off student loans, after the down payment on the house—you’ll find yourself only starting to think about retirement at thirty-one years old, like the average American, and you will likely retire with $2.5 million less in your account.
As I like to say, if you Invest Hard Now, you can Play Hard Later.
Books to Read About Buy-and-Hold Stock Investing
Here are some great books for new investors trying to learn the fundamentals of the stock market. Check out the Kids’ Money library of investing books for teens for even more recommendations!
In The Intelligent Investor, Benjamin Graham, widely considered the founder of value investing, lays out the strategy for determining a business’s financial worth based on intrinsic value for long-term investing.
Investing legend Warren Buffett certainly has the track record to deserve respect. The Essays of Warren Buffett compiles Buffett’s annual letters to Berkshire Hathaway shareholders into a single book and are surprisingly easy for beginner investors to follow.
John Bogle’s book, The Little Book of Common Sense Investing, goes into detail on why high fees will significantly reduce your earnings. Bogle revolutionized investing for retail investors like you and me when he invented the concept of the diversified, low-fee “index fund” in 1975.
Disclaimer: Luke Villermin (“the author”) is not a licensed financial advisor, registered investment advisor, or registered broker-dealer. The author is not providing investment, financial, legal, or tax advice, and nothing in this article should be construed as such by you. This article should be used as an educational tool only and is not a replacement for professional investment advice.