Finance for the Non-Finance Major: Once you’ve made some money, what do you do with it? (Part One of a 3-Part Series)

Concerned about your personal finances after graduation? Worried about loans, retirement, and investment planning? This article will help students who are not schooled in finance how to control and invest their money in a way that is comfortable for them. This is not a stock-picking article, nor is it intended for anyone who actually knows complicated finance instruments like options (you don’t need any help!). This is for the college graduate who knows they need to plan for retirement and invest their money wisely, but has no clue where to start.

If you’re reading this, you’ve already gotten over the first hurdle: realizing that just making money isn’t enough. Once you have it, you have to make your money work for you. One of the first things finance majors learn about is the time value of money.
The concept of the time value of money basically states that money today is worth more than the same amount of money tomorrow. Why? Because you can earn interest on that money. So my advice for anyone starting out is this:

# 1 Invest Early
I know you have student loans, rent, health insurance- things you’ve never had to deal with before. But think about this: in the next 30-40 years, you are going to want to retire.
How will you afford it? Take a look at this scenario:

$100 invested the moment you start your new job, at age 22.
Let’s say you in invest it an annual rate of 4.5%, compounding monthly.
By year 30 you’ve turned your $100 into $384.77

This doesn’t seem like much, does it? But think- you’ve tripled your investment!
So if you do it on a larger scale, investing early will earn you lots of interest income over your lifetime.

Let’s say you invest $100 at age 22, and continue investing $25 each month at an annual rate of 4.5%. $25 a month isn’t a lot, right? That’s one night a month you don’t eat out, or you don’t buy so many drinks at the bar. Here is what happens to your money:
By the end of 30 years, your $100 initial investment and your $25 a month turned into $19,369.42.

You put a total of $9100 into your investment, and earned twice that in interest- and without any extra time at the office!

One of my favorite comparisons is looking at $100 invested monthly between age 20-30, and $100 invested monthly between ages 40-50 (right before retirement).
Think you’ll save money for retirement later? Think again.

$100 invested monthly age 20-30. Never invested again.
Value at end of 10 years: $15,333.21
Value at age 60: $58,997.55

$100 invested monthly age 40-50.
Value at end of 10 years: 15,333.21
Value at age 60: $24,027.02

I don’t know about you, but I’d like the free extra $35,000!
Obviously my advice is not to invest $100 a month now and then stop. My advice is to start early and continue investing, so your nest egg will grow faster and bigger as you age.

#2 You are young- take risks.
A 4.5% return? Actually, this isn’t much at all. In fact, currently you can get a money market account (nothing more than a higher-return savings account) at about 4.8% to 5% today. And you are liquid- meaning you can take your cash out at any time without any penalty. But my advice is to start out with riskier investments, which has a greater potential for significant upsides and much higher returns. It also has the potential for significant downsides as well, which is why you want to choose “safer” investments as you age, so you don’t lose the principal and interest you’ve already accumulated. But at the beginning, taking risks will get you more money to put into risk-free or low-risk investments once you near retirement.

How do you do this?

My advice does not mean buy options of some great new stock your friend told you about. Financial management firms (comprised of very smart graduates schooled in finance!) have all sorts of complicated financial instruments to make money- often at the fool’s detriment. When you hear about Goldman Sach’s making millions of dollars in investments…remember there are always the guys on the other side of this equation who lost millions of dollars. Don’t let this be you.

So how do you take risks without losing tons of money?

You can’t. Or what I mean is, you can’t take risks without the potential of losing money.
So spread your risks out! Don’t put them all in one basket. If you are someone who doesn’t know too much about investments, definitely don’t try to pretend like you do.
My advice is to try index funds. Index funds are similar to mutual funds, except you are not paying anyone for their stock selection skills. Index funds are a sampling of all of the stocks in a particular index (for example, the S&P or the Dow Jones) without any fundamental or technical analysis of the stocks. I don’t particularly like mutual funds- basically managers are trying to beat the index and most of the time they fail. On a rare occasion, there are some that consistently beat the index (such as Peter Lynch), but these are very rare. Why pay someone to pick stocks (mutual funds have much higher expense ratios) when you can buy an index fund and get a much more diversified portfolio and better returns than half the mutual fund world, without paying someone to do it?
Index funds do have expense ratios because obviously someone has to make the trades and run the administration of the fund, but they are minimal. Mutual fund’s expense ratios are on average around 1.5%, and index funds are between on average .15%.
Big difference.

Now if you decide to buy an index fund, here is how you do so AND take on some risk (which hopefully lead to higher returns!). Index funds mirror a financial market of specific parameters, and so there are lots of them- each reflecting a different market. Try a small cap index fund, an international index fund, or an emerging markets index fund. These are all riskier investments made individually (e.g., investing in small cap stock is riskier than a large cap stock because the large cap stock has more money and generally a longer stable history.). However, when you invest in an index fund, you are not putting all of your money in one stock- you are putting it in lots of small cap stocks. So if one falls dramatically, chances are, another will rise dramatically. On the whole, you are looking for this particular index to do well and have the average of all the returns be high.
That is why I like the international index funds- China, Latin America, and Eastern Europe all have the potential to grow in the next decade. I like the Vanguard International Index Fund. The expense ratio is .32%, international stocks have done great recently and I believe they will continue (since inception (1996) 7.78% return, 5-year return 16.08%), and there are no fees if you invest over $10,000. Obviously that isn’t us yet- but still the fee is only $10 per year.

If you can’t find an index fund that covers the market you want (for example, say you want to invest in Home Construction stocks, or the Energy Sector), ETF’s, or Exchange Traded Funds, are an excellent alternative. Lately many ETFs have emerged in areas that have few if any index fund alternatives. ETFs, like index funds, have minimal costs and keep your portfolio diversified. The difference is that the exposure of an ETF is different- if you are investing in an energy ETF and the energy market plummets, your investment value will as well. If you are in an index fund and the energy market plummets, other sectors such as Home Construction will have an impact on your investment value and it won’t necessarily go down. ETFs allow you to further specify the type of stocks you’d like to own without forcing you to select certain stocks.

If you’d like to learn how to buy these investment tools to prepare for retirement (invest early!), tune in next week for my segment on 401(k)s and Roth IRA’s!!

To be continued next week…..