By: Alex Canitano
Today is the big day. You wake up, head to the closet, and throw on your cap and gown. It’s the day you graduate college. The dean instructs you and your classmates to turn the tassel from right to left, and you toss your cap in the air, excited and optimistic about what the future may bring. In this moment, your financial future and retirement savings plan is most likely the last thing on your mind. You may not realize it right now, but this is the perfect time to start laying the building blocks for a secure financial future. Below are five steps every young professional should be taking to establish their investment and retirement savings plan.
- Budgeting and Consistent Savings
One of the keys to building your financial future is by first understanding your monthly cash flow. The base formula is simple: income minus fixed and variable expenses equals monthly surplus/deficit. The goal should be to maximize the monthly surplus, and to invest that surplus wisely. If you realize you may be running a deficit, the goal should be to reduce discretionary expenses like entertainment, dining, travel, and subscriptions. Documenting your monthly expenses in a simple Excel spreadsheet should help identify the key factors impacting your monthly cash flow. Once you understand your financial habits, the next step is consistent and increasing monthly surplus. A good rule of thumb is to attempt to have a surplus of 15% of your income. These savings will become key to your financial roadmap and will need to be properly invested for the future.
- Understanding of Risk and the Emergency Fund
An important consideration that young professionals may often overlook is their understanding of, and ability to protect against, risk. Risk in the investment world is defined as the chance an investment return can differ or fall short of expectations. But in this context, we are talking about adverse life events that can hurt your personal finances. Unfortunately, worst case scenarios happen. While unlikely, a serious injury or accident can significantly impact your financial picture. Medical, home, and auto insurance likely come to mind first, as insurance is certainly the most common method of transferring this type of risk. As a young professional, you most likely don’t need the “Rolls-Royce” of insurance policies, but the policy you choose should protect against these worst-case scenarios. An often-forgotten piece of this puzzle is the establishment of an emergency fund. A strong recommendation would be to keep between 3 to 6 months of total living expenses in a highly liquid emergency fund. This would include both fixed and variable expenses, and most emergency funds are either kept in high yield savings accounts, or money market funds. While easy to forget or overlook, the emergency fund is a key strategy every young professional should have or be building to protect against unexpected risks in your life.
- Develop an Investment Strategy
One of the hardest things about investing is all the change and uncertainty going on in the world around us. So how does one sort through all the noise and decide how to invest. The smart thing to do is ignore all the noise and focus on the right long-term investment strategy for you.
Asset allocation is the process of dividing your investment portfolio into different slices, called asset classes. Each asset class reacts slightly differently to the market environment going on around us, thus allocating among different asset classes provides diversification. Various studies have shown that asset allocation is the primary determinant of portfolio returns. Determining the appropriate asset allocation for you can be a daunting process if unfamiliar with the risk & return profiles of different asset types, but do not worry, this is where a trusted financial advisor comes in to help. When determining an appropriate asset allocation, your time horizon will be a key factor. Your time horizon is the length of time an investment will be held before needing to be converted into cash. As a young professional, your retirement time horizon is almost certainly long-term, meaning 10+ years. Capital markets in the short term are volatile and relatively unpredictable, but over periods of 5-10 years, economic cycles smooth out, and asset returns tend to converge upon historical averages.
As a rule of thumb, virtually all young investors with a long-term time horizon of 10+ years should have a relatively aggressive asset allocation, meaning a sizable portion of investment assets being allocated to stocks. Generally, the largest chunk of your equity investments should be U.S. Large-Cap stocks. These are some of biggest and most profitable public companies in the world, today think about companies like Amazon, Nvidia, Microsoft and Apple, and should be the cornerstone of your investing future. With that said, diversification remains important at this stage. Small-Cap, Mid-Cap, and International Equities likely should all have a place in your portfolio to diversify risks and potential returns during different or evolving economic conditions.
Once an allocation strategy has been decided on, we must now address the ever-pressing question of: what actual investments should I buy? Here at Fairway, we are not individual stock pickers. We believe the most efficient and effective way to invest is using low-cost, tax-efficient index funds. Index funds are groups or “baskets” of stocks that are intended to replicate the return of an index. For example, the S&P 500 is the index of the United States’s 500 largest public companies, and ETFs (exchange-traded funds) like “SPY” and “VOO” are run to replicate that index’s return in a highly tax-efficient and cost-efficient way.
- Strategic Use of Investment Accounts
When most people hear the words “investment account”, they might immediately think of terms like brokerage account or 401(k) but might not know the strategies and advantages they offer. An important part of establishing your financial future is to understand how to leverage and strategize between account types. Beginning with workplace retirement plans like 401(k)s, 403(b)s, and more – these accounts are referred to as “Qualified Tax-Deferred Plans”. This means that the dollars invested into plans come out “pre-tax”, meaning those contributions lower your taxable income, reducing your tax bill. And investment returns, and investment income are not taxed until the funds are withdrawn from the qualified account, effectively “deferring” any tax consequences. When beginning your career, it is important to understand what plans and features will be offered by your employer, as well as if your plan contributions will be matched. For example, a common matching provision that companies could offer is “100% of your first 3%”, meaning that if you contribute 3% of your earnings to the plan, the company matches your contribution, adding another 3% to your retirement plan. This is free money the company is offering you, just for participating in the plan. A good rule of thumb would be to contribute at least up to the percentage that is matched by your employer. Additional contributions are certainly not a bad thing, if your monthly cash flow can support it.
Another type of account, potentially one of the most advantageous investment accounts available, is the Roth IRA. Contributions to a Roth IRA give the accountholder an opportunity to make tax-free “qualified” withdrawals, assuming certain conditions are met. To be a qualified withdrawal, the most common requirements are that the Roth IRA account must have been open for at least five years, and the owner must be age 59 ½ or older when taking withdrawals. Withdrawals relating to the death or disability of the owner are also included as qualified, but less common. These accounts are one of the rare ways to avoid paying taxes on your investments all together, and a concentrated effort should be made to “max out” contributions for the year, especially when at the beginning stages of your career. The contribution limit for these accounts is lower than 401(k) accounts, with the 2025 max being $7,000. So, directing savings to contribute to a Roth IRA is a great use of resources, ideally with the next dollars available after contributing up to the company match in a 401(k) plan.
- Discipline and Removal of Emotion
At this point in the process, we have laid out some key steps that a young professional should be taking for their financial future, but this last part is essential: staying disciplined and committed to your plan. It’s one thing to have a plan, the hard part is sticking to it. Market environments with short-term fluctuations and volatility can be scary, especially if you haven’t gone through down markets before. However, these times are exactly when having a well-constructed plan is important, as you can avoid making emotional decisions by sticking with your long-term plan. From point #3 above, if you are a young professional, your time horizon is most likely long-term and you will have to weather the storm of multiple economic cycles. You are in the accumulation phase of your financial life and should use volatility as buying opportunities, not by panicking when markets go into decline!
Beginning your professional life and starting off in your career is a very exciting time in your life and should be treated as such. While it may be far from the first thing on your mind, this is also the perfect time to launch a successful financial plan by following these 5 steps that every young professional should be taking.
