Generation Z and millennial investors have a powerful tool at their disposal to build considerable long-term wealth, financial advisers say.

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“I jokingly refer to the power of compounding [being] the eighth wonder of the world when I’m talking to young people,” said Graeme Egan, portfolio manager and head of CastleBay Wealth Management Inc. in Vancouver.

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Compounding allows you to earn returns on the gains on equity investments or the interest on fixed income and then greater returns on those gains when you re-invest the money.

“The runway of life is a long one ahead of you. Keep adding as much as you can to your savings regularly – it’s going to the power of compounding.”

Darren McKiernan, senior vice-president and portfolio manager and head of the global equity and income team at Mackenzie Investments in Toronto, said, “the power of compound interest means that even very small differences in timing can have outsized consequences to the end results of your investments.”

The power of compounding

For example, if a 30-year old starts putting $5,000 into a savings account such as a registered retirement savings plan (RRSP) every year, at age 60, assuming an eight per cent annual return, approximating longer-term historical returns on a United States equity-based portfolio, that will grow to over $650,000 in that 30 year period, said McKiernan.

But if they begin investing at age 20, again assuming eight per cent growth annually, that will have already provided an additional nearly $90,000 by age 30, which will grow to more than $1.5 million by age 60, he said.

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Many experts advise young investors to focus on equities to provide them the optimal long-term growth needed for wealth building.

“If you’ve got some money you want to set aside for the long-term, go 100 per cent in equities,” said Egan.

He also recommends exchange-traded funds (ETF) because they are low cost, diversified, transparent, and liquid investments, as they trade on a stock exchange. And if an investor is not interested in picking individual ETFs, a Canadian ETF or U.S. ETF can be purchased as all-in-one bundled ETFs covering all areas of the global stock market, with a growing number of ETF sponsors offering them, he added.

Fees on investments are also an important consideration. “I don’t recommend mutual funds because of the relatively high management expense ratio costs,” Egan said.

Diversification

Diversification is another factor to consider, said Maili Wong, a senior portfolio manager and wealth adviser with Wellington-Altus Financial Inc. in Vancouver. Young investors should have a diversified equity portfolio covering different geographic and industrial sectors, she said, noting that young investors might be more comfortable than older investors with certain growth sectors such as new technologies. However, a balanced portfolio should also include other major sectors such as healthcare, industrials, and financials, she said.

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“I have always told young folks,” McKiernan said, “there are great investments hiding in plain sight, … companies all over the place that end up being very good investments.”

Investors should think about the common tools and products they use in their work or at home, and consider investing in the businesses that produce those tools and products which are in popular demand, and have provided excellent historical returns in the stock market, he said.

“It’s a very simple strategy. You own businesses that you think you understand, and that produce products and services that are going to be in demand for many years. And as a young person, you can take advantage of that, and the math behind compound interest,” McKiernan said, echoing famed investor Warren Buffett’s advice to invest in what you understand.

Volatility: risk and opportunity

Volatility in the market can sometimes lead to investor uncertainty, especially from new and inexperienced ones, Wong said. “However, we always say, especially for young folks … if the markets go down, that’s great for them, because then they can put their earning power, their savings, to work and buy at discounted prices,” she said.

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“The people who have the highest returns [among] the people that I look after, are the people that send me money during the tough times,” said Chris Raper, co-founder of Aspira Wealth of Raymond James Ltd., and a senior wealth adviser and portfolio manager of the company, based in Victoria.

Younger investors are the precise demographic that should be taking some risks, Wong said. “Invest in a growth type of portfolio, ride the ups and downs, use the downs as an opportunity to buy more investments, and take a disciplined and patient approach to letting that compound in value over time,” she added.

Near-term goals and tax efficiency

Some fixed-income investments could also be useful in the portfolio, especially for a near-term goal, Wong said. “For example, a lot of times young people are trying to save towards their first home, and so they might have a plan to use their first home savings account (FHSA), to buy a home some time in the next five years or so.”

The FHSA is also a tax-efficient program for young people buying their first home because it allows users a tax deduction on their contribution, tax sheltered growth of their investments within the plan, and then a tax-free withdrawal when money is taken out for their home, said Egan.

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Fixed-income instruments in the portfolio can provide a steady income stream, with higher interest than what the investor would get in a savings account, depending on the type of bond or other investment in the portfolio, said Wong. Again, compound interest can allow you to earn interest on the money you have saved as well as on the interest you earn.

Younger Canadian investors also have the opportunity to shelter a large portion of their money through RRSPs and tax-free savings accounts [TFSAs], said Raper.

The RRSP contribution attracts a tax deduction up front, and is not taxed until funds are withdrawn. The TSFA contribution is made with after-tax dollars with no tax consequences upon withdrawal.

Regular and consistent contributions to an investment portfolio allows investors to purchase underlying investments such as equities on a dollar-cost averaging basis without having to worry about whether it is a good time to buy on the market, because over the long term that timing won’t matter, said Raper.

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