Listen to our podcast episode with this article's author Doug Allan, CPA, CA, where he provides investment advice that every teenager should know. Part of our Coffee Chats with CPABC podcast series.
A common excuse many young people have as to why they haven’t begun the process of putting money into investments is that they don’t have enough to start. Somehow, we’ve become conditioned to think “it isn’t worth it” unless we have thousands and thousands of dollars to invest. But you can start with very little, and the earlier you do the more that money can grow.
Compounding is a powerful force
One concept which receives far too little attention is “compounding”. Simply put, compounding is the concept that when money is invested, it earns returns, and then subsequently those returns earn even greater returns.
Over a long period of time, the process grows exponentially like a snowball rolling down a hill, picking up increasing amounts of returns as the base capital grows.
Consider the following scenario. The average return of the S&P 500 stock market index is roughly 10% per year over the past several decades. If someone invests just $100 at age 15 from their first summer job, and leave it in a passively managed S&P 500 exchange-traded fund (ETF) until they retire at age 65, that single $100 investment at a 10% growth rate compounded annually will grow to $11,739.
However, if that same young investor waits to invest that first $100 until they are 25, that $100 will only grow to $4,525 by the time they turn 65. As a result, the young investor would have lost 60% in potential growth by losing out 10 years of compounding growth. This is the exponential power of compounding, and why it is important to start investing as soon as feasible.
Opportunity cost and the trade-off of choices
Building on the concept of compounding is a foundational lesson not taught in school, which is the concept of “opportunity cost”. This is the theory that each financial action we take comes at the cost of taking other actions which results in different outcomes. For example, if we spend $100 on a video game when we are 15 years old, it comes at the opportunity cost of putting that same $100 to work in an index fund for 50 years and having almost $12,000 in retirement.
Opportunity cost should be constantly on our minds whenever we must make a financial decision. It is important to remember that the decisions we make today can impact our prospects for financial success. As the saying goes “live like no one else today, so you can live like no one else in the future”, meaning that small sacrifices today can pay huge dividends over time.
The theory of compounding means that the opportunity cost of not investing money is the greatest when we are young and reduces over time as we have less time for compounding to take effect.
Tax advantaged investment vehicles
The final lesson for young investors to grasp is that there are significant advantages that our government has given us to grow our wealth, such as the Tax Free Savings Account (TFSA). Often misunderstood as a “savings” vehicle to hold cash, the TFSA is actually the ideal place to begin growing your wealth through investing because once money is contributed to it, no further tax is ever owed.
The TFSA allows investment in a wide variety of investments including ETFs, mutual funds, stocks and bonds. When you’re young and starting with a small amount of initial capital, which is relatively easy to replace should it lose value, you can afford to take more risks than if you are investing a large portfolio later on in life.
The TFSA is the perfect place to take on some risk and put money to work, because the more gains that result in a tax advantaged account, the more tax you’ll save.
Start early, no matter how small
There’s no doubt that investing can be intimidating for young Canadians. However, as mentioned earlier, it is completely fine to start small. Thanks to compounding, even a little investment made early in your life can grow rapidly over time. When choosing how to spend your money, keep in mind the opportunity costs. By making the decision to put a bit of cash aside to invest today, you will end up with a lot more wealth down the line.
Doug Allan, CPA, CA, is the vice president of finance and operations at Burrard Properties. He is a CPABC financial literacy volunteer and is the author of A Fighting Chance: The High School Finance Education Everyone Deserves. For more information about CPABC’s financial literacy program, visit CPABC's FinLit site.