This month, thousands of college students will sit scrunched together in flat hats and itchy robes while listening to commencement speakers give sweeping platitudes — and little practical advice. Given that high schools and colleges provide students with next to no education in the vital area of managing their own money, they might do their newest alumni a favor by replacing graduation ceremonies with seminars in personal finance.
Since that's unlikely to happen, here are seven things that I wish I'd known about money when I graduated.
Owning individual stocks is gambling — not investing. So much of the stock market is governed by things that you can't control: investor emotions, information that you aren't in a position to act on and macroeconomic trends that pull good companies down along with the bad.
By buying only one company — Apple because you like your iPhone, Google because you use Gmail, General Electric because your dad told you to — you are essentially playing roulette, no matter how strong the company's fundamentals may look. Maybe this company will continue to do well and you'll prosper, but maybe the ball will bounce elsewhere. Some people bought Amazon.com at the right time and made millions; others bought AOL at the wrong time and lost just as much.
The alternative is to invest in index funds. Unlike an actively managed mutual fund where stock-pickers select companies that they think will do well, index funds track broad markets, ranging from the 500 companies that best approximate the overall economy (known as the Standard & Poor's 500) to every single stock in the world. When you own an index fund, the good-performing stocks balance out the bad ones, and you get the market average in return.
Index funds will not rescue you from doing poorly in a bad market. But over the long term, they will provide you with low costs, high tax efficiency, broad diversification and, if history is any guide, respectable returns that beat those of the vast majority of individual stocks and actively managed mutual funds.
Waiting to contribute to a retirement account will cost you. Like eating spinach and getting a yearly physical, setting up a 401(k) is one of those things people know they're supposed to do — but often put off until tomorrow.
Here's why procrastinating will cost you. Employee-sponsored 401(k)s let you buy stocks, bonds and mutual funds with pre-tax dollars. Once the money is invested, it can compound for decades without your having to pay a dime in taxes. Many employers will also match a portion of the money that you put into your 401(k). On the most basic level, not setting one up is turning down free money.
Then there's the compounding. Suppose you buy a stock fund that pays $1 in dividends every four months for each share you own. Through your 401(k), you aren't taxed on that dollar and instead can reinvest it by buying additional shares (or portions of them.) When the fund next pays a dividend, you'll receive a payout not only on your original shares but on the new ones too. That compounding effect will continue, and become increasingly amplified, the longer you own the account and continue to reinvest your dividends.
If your company doesn't offer a 401(k), or does not match employee contributions to it, consider setting up an IRA or a Roth IRA.
Knowing what you own in your 401(k) is just as important as opening one. When I started my first job, I signed up for my company's 401(k) and opted to put all of my contributions into the "aggressive" investment option. Only much later did I realize I was putting all of my retirement money into mutual funds with outrageously high fees. Known as expense ratios, these are the amounts deducted each day from mutual fund accounts.
On first blush, it's easy to think a 2 percent fee isn't bad. That's what fund companies want you to think. That 2 percent looks a lot higher when you realize it can gobble up a significant portion of a fund's net return after inflation. What's more, you can buy index funds that are almost certainly going to perform better than actively managed funds over the long run and cost 95 percent less. These lower-cost funds are available from fund families like Charles Schwab, Fidelity and Vanguard.
If your company's 401(k) offers more expensive alternatives, ask if you can opt for a self-directed account and pick low-cost funds yourself. Or opt out altogether, if your company is not matching contributions, and set up an IRA or Roth IRA on your own.
Getting the right mix of funds is important too. A good rule of thumb is that the percentage of bonds in your portfolio should match your age: if you're 25, then put a quarter of your assets in bonds; if you're 35, make it 35 percent and so on.
A reasonable portfolio for a recent graduate would put about a third of all contributions in a S&P 500 index fund, a quarter to a total stock market fund, a quarter to a bond index fund and a tenth each into a small-cap stock index fund and an international stock index fund.
Make more than the minimum payment on your credit cards. If you are an average college graduate, you owe about $3,000 in credit card debt. While recent legislation will make it harder for anyone under 21 to get a credit card, there are plenty of 22- and 23-year-olds who will spend money they don't have because they believe their wealthy future selves will be able to pay off the debt. Instead, many end up stuck in credit card purgatory, forever paying off that $1,000 they used on a vacation to Italy.
Credit card companies love customers who don't pay off their full balances because they end up making years of interest payments without paying off the principal. If you are only making the minimum payment each month, you are putting yourself in the shoes of Sisyphus, who, as punishment from the Greek gods, was forced to roll a boulder up a hill for eternity.
Take someone who owes $3,000 on a credit card that charges 15 percent interest, which is the average interest rate for all types of credit cards. If she only makes the minimum payment of $70, it will take her 14 years and five months to pay off her debt. Over that time, she'll pay $2,700 in interest, for a total payment of $5,706.
If she puts an extra $30 to her payment each month, it would only take her three years and 2 months to pay it all off, and the interest payment would only add up to $724. By spending only a little bit more each month to pay off her debt, she will save almost $2,000 and pay one-forth the interest.
Your credit score matters more than your SAT score. Just as your SAT score helped colleges gauge your ability to handle critical thinking, your credit score allows lenders to measure your ability to handle your money. That, in turn, will determine how much you pay for a mortgage, your interest rate on credit cards or student loans, and even your ability to rent an apartment.
It's important to have a clean credit history, but also one with sufficient bulk to tell potential creditors about you. The landlord of one recent grad forced him to give two months' rent as a security deposit instead of one because he didn't have a credit card.
Using a credit card every so often, and paying off the balance immediately, can help you get a better loan if one day you decide to borrow for a home purchase or a small-business loan. If you don't trust yourself to use a credit card, at least be sure to make your phone, car loan and student loan payments on time.
Saving is a form of freedom. The key to financial well being is spending less money than you earn. That way, when something unexpected happens, like a major car repair or illness, you will expand your options for dealing with it. Every dollar that you save means one less dollar that you may have to borrow (and less money that you will then have to pay back with interest).
If you have a hard time not spending whatever is in your pocket, consider setting up automatic withdrawals that will put money into your savings account before you even see it. If you have a steady job, for example, you can have a certain dollar amount or percent of your income sent directly from your employer into a retirement or bank savings account with each paycheck, reducing the temptation to spend your last dime.
You can get almost everything cheaper. There are lots of ways to save money — if you do a little homework and planning. There are more than 60 tax credits and deductions for things ranging from going to graduate school to paying off your student loans to putting solar panels on your house. If you are already doing any of these things, the money is there for the taking. The easiest way to save money, of course, is not to spend it in the first place.