by Aram Kupelian
Considering the amount of time we devote to earning, spending, thinking about and talking about money, you would think that it would form an important part of the school curriculum. However, many people finish their education without an understanding of money or how to manage their finances as they enter adult life.
As we know, finance is a complex subject. However, there are some simple concepts that young adults can learn early on that can foster good behaviour at an early age, help to avoid pitfalls and offer significant value throughout their lives. Here are five financial concepts advisers working with young adults should teach.
One: Money Isn't Boring
Engagement with finances at an early age is key. The problem is that we as a population often perceive money as a boring subject. While money can be dry, we can easily remould it into something more interesting. Money allows people to do interesting and exciting things. It gives us the freedom to live our lives the way we want to, to not only achieve our dreams, but help others. This is anything but boring! Getting this empowering message across should inspire people to engage with money at an early age.
Two: Maximise The Impact Of Time
Saving at an early age not only encourages good habits, but gives an opportunity for compounding returns to work their magic. The longer the time frame, the greater the final value could be. Time arguably has the biggest impact on an investment portfolio, which means that young adults are in a powerful position. Over a long period, a small sum of money can grow into a very large amount through the power of compounding. Speaking of compounding…
Three: Compounding: Friend & Foe
Friend
Explain to young adults that compounding returns happen when you achieve a return on previous returns. This makes an investment grow at a faster rate than the simple rate of return, calculated only on the original invested amount. The earliest returns are reinvested for the longest time and therefore generate greater returns, so it is important to start saving early in order to maximise the benefit of compounding.
Illustrating the impact of longterm compounding can be an extremely powerful tool to motivate early saving habits amongst young adults. The following chart shows the impact of compounding on an investment of £10,000. Growth rates are net of charges.
Return/Term4%6%10 years£14,802£17,90820 years£21,911£32,07130 years£32,434£57,43540 years£48,010£102,857
Foe
Unfortunately, compounding happens to debt as well. Instead of achieving returns on returns, we accrue interest on interest. Therefore, it is important to pay off debt as early as possible. Making only the minimum payment every month can get expensive as interest increases.
Illustrating the impact of compounding on debt can be a scary deterrent for young adults to getting into debt as they enter adulthood. One example from moneysense shows a credit card bill of £5,000, with interest fixed at 25%. If you only pay the minimum amount, by the time the debt is fully paid off, you would have paid £13,500 for a £5,000 loan.
Interest is not the only cost of the debt. There is the opportunity cost of not investing those monthly payments. What if you had saved the £50 per month payment for 14.5 years? You would have saved £8,700, even without interest.
Four: Understand Credit Ratings
Debt is sometimes unavoidable and necessary. Most students enter debt while in university. Later in life, many people will take on a huge debt in a mortgage. However, young people must realise that if they manage their debt correctly, they can use it to build a positive credit rating.
Explain to graduates that credit ratings are important because they determine how much companies are willing to lend them. This is crucial when applying for a mortgage or renting a house. Young adults must realise regardless of the debt, it is crucial to make repayments on time to usually improve their credit score. Missing repayments will usually lower the score and reduce their chances of being able to borrow money in future. Although some companies will lend money to people with a low credit rating, it will be much more expensive.
Five: Respect Inflation - An Underrated Risk
When investors discuss money a common fear is the stock markets crashing. However, over the long term there is a strong argument that the biggest risk of all is that of inflation. Consider that £10,000 in 1990 is now worth £6,293, (2) a nearly 40% loss in real monetary terms over a thirty-year period. Young adults must know to combat this, after setting aside a fund to cover emergencies and short-term expenditure.
The issue is that most people consider cash deposit accounts to be a safe place for their money. While they're appropriate for short term expenditure and emergency funds, for longer term saving the suitability of cash deposits is questionable, when even the best rates are typically lower than inflation.
Young adults may feel hesitant to take risk, especially if they're coming off the heels of debt. But they must understand taking some equity risk is likely to be necessary for most people. We can assure them by explaining history tells us that over the majority of time periods, investment in shares beats the return offered by a cash deposit account and importantly, inflation.
Although these five tips just scratch at the surface of building a solid financial foundation, they are a great start for building understanding amongst young people.
Aram has worked in financial services for 18 years. He is a Fellow of the Personal Finance Society, currently leading the Paraplanning team at Holden and Partners.
