Investing Tips for College Students

Someone asks in Yahoo! Answers:

I am 22 years old, in college, and I want to retire when I am 40. I have $3,000 to invest? What is the best investment strategy for me to use now, so that I can retire at 40. I'm thinking of buying ETFs but I need to know more about them before investing.

The problem with exchange-traded funds, for a case like yours, is that, as far as I understand, you intend to add a little money every month. That practice, called dollar cost averaging, would mean buying ETFs frequently, which would produce transaction costs that you can avoid if you invest in ordinary no-load mutual funds through companies such as Vanguard, T. Rowe Price or Fidelity. Whatever account you use, check its tax stance: you may prefer this investment to be in a tax-deferred account like a 401(k) if you are a U.S. citizen. Also verify if there are any extra expenses for the mutual-fund accounts, such as extra charges for non-U.S. citizens, or low-balance fees. Sometimes these additional costs appear, making an ETF portfolio in an ordinary brokerage account to be less costly, as long as the dollar cost averaging is managed well.

Be it through ETFs or mutual funds, you need to assemble a diversified portfolio. At the beginning, I would recommend allocating most of the capital, if not all, in stock, because your investment horizon is long term. If the market goes down, there is enough time until your retirement for it to recover. As your planned retirement approaches, shift the allocation towards less-volatile instruments, such as bonds. Real-estate and commodities don't look too good and I don't think the amount invested is high enough to justify diversifying through those alternative asset classes.

Regarding country selection, you may want to more or less reproduce the world economy's capitalization but with a bias towards your own region or country, because I presume it is where you will be spending your savings. This bias is convenient because your future expenses will be related to the performance of your country's markets. If you are living in France and your investments are mostly U.S. assets, a crisis in the U.S. would make your savings too low in comparison to your expenses, which wouldn't be the case for U.S. citizens as their expenses would also lower (if measured in euros).

You should also allocate a portion on emerging markets, which offer potentially-higher returns (but higher risks too, I'm afraid) and small/medium capitalization companies. The following allocation looks adequate, if you live in the U.S. (please receive these investing tips with caution, I'm not a certified advisor):

  • 25% in a S&P500 index (U.S. large cap), such as VFINX (mutual fund) or IVV (ETF).
  • 20% in developed-world ex-US large cap index, such as VFWIX or VEU.
  • 20% in small cap U.S., with TRSSX or IWM for example.
  • 15% in developed-world ex-US small cap, with VINEX or GWX for example.
  • 20% in emerging markets, with VEIEX or VWO for example.

Similar funds are offered by the other fund families that I mentioned before. Make sure the funds you buy are no-load and have small annual expenses, because there is no reason to pay high entrance costs and premium fees. You might be offered load funds with lower annual fees compared to similar no-load ones, that may thus be less expensive in the long run, but if you search the offerings from the 3 fund companies I mentioned before, you will find no-load funds with small fees that will beat any load fund.

You can opt for broader funds, such as Wilshire-5000 indexed which covers all the U.S. market (large, mid and small cap), if you need to keep the number of funds very low to minimize costs (transaction ones if you invest through ETFs for example), but make sure that higher fund fees don't cancel that advantage.

Gradually modify the allocation towards fixed income (or bonds), to end with about a 40% stock and 60% bond distribution at the time of retirement. By the way, I keep wondering why you want to retire at 40. . . You will still be so young! Anyway, if you change your mind by then, I guess having some nice savings won't hurt.

Besides increasing the percentage allocated to fixed income, you should regularly re-balance the portfolio, which means returning it to a planned distribution, since it will drift away because of differences in the price changes of each security. For example, if non-U.S. stock falls and U.S. stock rises, you will have too little of the first in relation to the latter. So either buy only those funds that have too-low an allocation when you invest your monthly savings, or sell from some funds to buy from others every 18 months or so, to go back to a convenient allocation.

Another part of your plan is finding out how much money you need to save each month to accomplish your goals. I think there are some tools on the Web for calculating that offered for free. Bear in mind that the portfolio may return an average of a 7% annually after we substract the effect of inflation (don't forget to consider the taxes you might have to pay on that), and that return would gradually diminish as you increase the proportion of bonds.

I doubt very much that you will be able to retire after only 18 years of savings or less, if you depend on your saving only, but investing and planning in advance are always good ideas. If your plan is not realizable, better to know it as soon as possible, and you may find that with some tweaks it can become feasible.

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