There is a belief among some in the investment advisory circles that the only way many pre-retirees can make up for not saving enough money is to invest aggressively, so that the supposedly higher stock returns make up for the missing savings. Similarly, young people are often advised to go all out and invest mostly in stocks. This is backed up by the claim that their ‘longer horizon’ will allow for long term stock growth.

Both of these suggestions are not only wrong, they are very dangerous and can potentially result in financial disaster. Stock returns, whether long or short term can not be taken for granted, and even if you’ve been investing for 50 years, all it takes is a big crash to lose a very large portion of your savings, if these are invested primarily in stocks. Young people are especially vulnerable because their risks are much higher, because the longer your horizon, the higher the risks of losing money in the stock market. Thus, young people can afford to be conservative with their savings, precisely because of their longer horizon. There are ways for young people to boost their savings, however, which can work better than gambling in the stock market. One thing many people do not realize is that investment returns are most likely a distant third source of your total return. Your total return looks something like this:

Total return = money saved + money not spent + investment return (gain or loss).

In this equation, what you’ve saved will most likely be the most important component of your overall wealth. Trying to maximize this equation by maximizing investment return is a sure way to lose money unless you get very lucky. Stock market returns can enhance and they can hurt you badly, if you rely exclusively on the stock market. This is why if you do have a long horizon and you are a good saver, it is not necessary to play the stock market roulette, at least not as much as some ‘experts’ suggest. One reason is that most people have no idea what they are doing in the stock market, and many indeed rely on luck, so for many, staying away will actually help more than it will hurt. Investing your money in an extremely risky fashion, and then hoping to get a huge multiplier out of that over 40 years is madness. For most people, not spending can contribute quite a lot to the total return, possibly much more than portfolio return. So instead, because young people have a much longer horizon, they need to concentrate on saving and not spending.

Here are several ways that can help avoid spending too much:

  • Avoid all debt, and/or pay it out very fast.

Reason: Debt costs a lot more than the loan value because of high interest rates (as much as twice the original amount and possibly more).

  • Invest while maintaining a good cash reserve.

Reason: Cash will help in case of layoffs, career changes and emergencies, and it will protect you from foreclosure if you bought a house (with leverage).

  • Buy a house with cash if you can, and avoid leveraged debt.

Reason: Leveraged debt of any type is very risky because the losses are amplified (just as gains are).

  • Do not get suckered into believing that kids cost $200k+ until they turn 18 (and that another $200k+ has to be spent for their college, etc).

Reason: Kids can actually earn money once they are given an opportunity, and spending excessively will not make them into better kids – your time with them is more important.

  • Let your kids take their loans, and try to make them aware of the choices and opportunities instead of simply putting your own retirement at risk by giving them too much money for useless (even useful) degrees.

Reason: Many of today’s 4-year degrees are useless when it comes to getting a real job. If your kids insist on getting such a degree – let them do so with their own money. They’ll be a lot more hesitant especially if they know they’ll have no chance of getting a well-paying job.

  • Don’t get suckered into ‘good school district’ game by purchasing expensive real estate.

Reason: Buying an unaffordable and overpriced house in a supposedly ‘good’ school district is a good way to overpay for the house. Given the fact that most people move around quite a lot because the economy is in a constant state of flux, having to sell the house early can lead to very large losses. One can easily rent a much cheaper condo or a house in the same neighborhood and be ready to move when needed.

Baby boomers were able to accumulate wealth in part because the cost of college and real estate were much lower relative to their salaries than they are today. They also tended to work to support themselves, and were generally much more independent. Over the past decade, salaries have not grown much, while college costs and real estate prices became totally unaffordable for most people. Thus, the biggest challenge for generations X and Y will be the expenses associated with raising children, which include buying a house in a ‘good’ public school district, and paying for their children’s degree, and possibly for more than one degree. Most families will not be able to afford either, and only a small percentage will be able to retire comfortably after they take on these expenses.

Young people have to understand that their financial situation is far from stable, and so they have to make their decisions based on what they can afford, rather than what everybody else is doing. It is not necessary to buy real estate, as it can be very volatile and illiquid. Just because somebody else made a profit doesn’t mean that everybody is making a profit. Changing jobs will make it much more difficult to sell in the current real estate market, and the risk is simply too great that you will run out of money before the market comes back to reward you for holding on.

The goal is to become financially independent so that you can work when you need to and enjoy it. This may sound unrealistic given today’s realities, but I think it can be done by almost anybody with proper planning. The difference between baby boomers and their kids is that while boomer’s salaries were smaller, their expenses were much smaller, so doing the same things they did will simply not work for generations X and Y in the future.