Managing your Money in your 20s

For many, their 20s represent the first decade in their life as an adult. You’ve left home, joined a profession and are ready to make your way in the world. It’s time to lay the foundation for the rest of your life.

That’s an intimidating phrase, isn’t it? “Rest of your life.” It doesn’t have to be, at least when it comes to taking care of your money. Allow me to introduce your wallet’s best friend – or worst enemy.

Compound Interest

There’s a quote attributed to Albert Einstein. It goes something like, “The most powerful force in the universe is compound interest.” Now, a quick Snope calls the attribution into question, but Dr. Einstein was known as a rather intelligent man. Even if he did not say such a thing, shouldn’t the fact that so many believe that he could have mean that we should all know a little bit about this force?

Consider the following question posed in The Random Walk Guide to Investing, by Burton G Malkiel:

“William and James are twin brothers who are 65 years old. 45 years ago (at the end of the year when he reached 20), William started an IRA and put $2K in the account at the end of each year. After 20 years of contributions, William stopped making new deposits but left the accumulated contributions in the IRA fund. The fund produced returns of 10% per year tax-free. James started his own IRA when he reached the age of 40 (just after William quit) and contributed $2K per year for 25 years, making his last contribution today. James invested 25% more money in total than William. James also earned 10% on his investments tax-free. What are the values of William’s and James’s IRA funds today?”

The answer? William has $1,365,227. James has $218,364. He invested $10,000 (25%) more than William.

The average return for the S&P 500 from January 1, 1871 to December 31, 2010 is 10.62%.

The average APR for a credit card at the time of this article is 14.83%.

Get the picture?

Disaster – It Could Happen to You

Yes, I know, between waving a stick at you while talking about the rest of your life and threatening you with disaster, you must really be loving me by now.

Here’s the thing. When you’re young, if everything’s gone mostly well so far, you’re filled with a sense of invincibility that you take for granted – and rightfully so. It’s unlikely that you’ll ever be more energetic or attractive than you are right now, and the world is yours for the taking. Despite this, it’s almost certain that at some point in the not-so-distant future, something cataclysmic will happen to you. And, truthfully, there’s a good chance you might not even think it’s a bad thing.

What? You never plan on having a child? Getting married? Buying a home?

Face it: Even if you think there’s absolutely no way you or a loved one could have an accident or have anything else happen that would prevent working for several months, you need a plan.

An Emergency Fund is Your Friend

I led off talking about compound interest because I really believe that it’s the one thing everybody should know when it comes to money, but when it comes to the actual allocation of your money, an emergency fund should come first. Even if you live the rest of your perfectly-healthy life in an apartment as a swinging bachelor(ette) who never gets “made redundant,” a solid emergency fund will keep you from acquiring high-interest credit card debt when your car breaks down.

So what is an emergency fund, exactly?

An emergency fund is basically a sum of money that’s kept separate from the rest against those days when Fate really takes an interest in you. You want to have this money handy, but not too handy. After all, it won’t do you any good if you can’t access it for a week, and it will be even less useful if you’ve spent it all on way too many Friday nights to remember (and mostly on things that make remembering a bit hard to begin with).

It should be large enough to keep you on your feet for at least 3 to 6 months if all your current sources of income were suddenly cut off. A year is even better, but don’t go too far overboard – you do want your money to work for you, after all, and even an interest bearing checking account (such as ING’s Electric Orange – which is a great product, by the way) will do little besides help defray the costs of inflation.

Don’t worry if you don’t have $10,000 under your mattress (but do worry if you do, especially if you’ve told anybody about it). Start small. Save $100. Good. Now $200. $500. Whatever your circumstances, you’ll get there eventually, and there will come a day when you’ll be very glad you did.

Your 20s are When Finance Gets Personal

Look, personal finance is a big, scary topic, and books upon books could be written about it. In fact, I’ve heard that there are a few out there. There are a lot of other things you should know about budgets (track your money for a month – what you find out will surprise you, or at least allow you to plan for the future), investments (when in doubt, invest in a life-cycle index fund such as Vanguard’s, and buy and hold), tax-sheltered investment vehicles (max out your employer’s 401k match, then max out your Roth IRA contribution – if you still have more money to invest, put the rest in your 401k), credit ratings (have a credit card or two, but pay off your balance every month), mortgages (have a solid employment history and be very happy you followed my advice on credit cards while you shop around for the lowest fixed-rate loan possible), paying down debt (kill high-interest debt with fire, manage your housing and student loans), and trusts (not touching this one).

It’s up to you to arm yourself with knowledge to keep others from taking advantage of you. The small bit of knowledge I’ve imparted here will go a long way towards securing your financial future, but there are a number of resources out there that can better help you understand what I have and haven’t said. In particular, I recommend a blog called I Will Teach You to Be Rich written by Ramit Sethi (he also has a book by the same title). Both are written for 20 and 30-somethings, and I tend to agree with most of what he’s written. But if it’s not your speed, there are a lot of other high quality resources out there.

It’s simple, really: You need to learn how to manage your money, because there are plenty of other people out there who already know just what they’d like to do with it.