Investing Tips for New Grads

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. It's graduation season and I'm here today with Christine Benz, our director of personal finance, for her tips for new grads.

Christine, thank so much for joining me.

Christine Benz: Jeremy, it's great to be here.

Glaser: So, your first tip is to maybe avoid lifestyle creep, which is starting to live maybe outside of your means when you're outside of college. Does this mean you should stick with ramen noodles forever?

Benz: Well, there is a lot of sodium there, so you want to bear that in mind. But my broader point is that in talking to financial planners one thing I often hear from them is that they feel frustrated that their clients seem to be able to grow into whatever income they have. So, whether it's $50,000 or $200,000, their clients seem to find a way to be able to spend that income. And we all know how this goes, that there are naturally a lot of things bidding for our cash.

My advice though to new grads is that if you have been used to living a fairly frugal lifestyle, as most college students have been, take advantage of that. If you've got a first job and you've got some salary coming in the door, resist the urge to spend it. Try to keep your budget down. Try to maybe live within your means and get your investment program up and running. That may be that you are paying down your student loan debt while you are investing in the market, but the basic idea is to set a budget so that you are setting money aside to help improve your financial picture.

Glaser: Let's talk about that student loan debt versus investing question. Seventy percent of grads are coming out with loans; of those who took out loans, $30,000 is the average balance. So, that's a big balance. How do you prioritize paying off those loans versus getting started, getting that compounding working for you in the market?

Benz: It's a tricky balance to be sure, and the fact is that most people will have to multitask. I think what you want to resist the urge to do, though, is to defer any investing program until you are fully done with that debt paydown. That for most people, especially if they have got that first job, may be a 401(k) plan they can contribute to, that you probably want to do both at the same time. The exception would be if you have some of that private student loan debt, some of those loans have very nasty interest rates attached to them. In that case, you'd be really hard pressed to out-earn in the market what you can earn by paying down that debt. So, you want to balance it. But generally speaking, most investors will want to do both at the same time.

Glaser: You say the Roth IRA is a good place to get started with investing. Why do you think this account type is attractive?

Benz: The first step I would say is for investors who do have jobs and they have company retirement plans they can contribute, to their first step should be contributing enough to that plan to earn any matching contributions. But I do like a Roth IRA as a good all-purpose starter savings vehicle because it's so flexible. So, many young investors know that they should have some sort of an emergency fund. We often think of that as three to six months' worth of living expenses set aside in cash. But they also want to invest for the long term.

A Roth IRA gives you the ability to do both. So, you can invest with the long term in mind but you can also get access to that money, to your contributions, at any time and for any reason without any taxes or penalties. So, it's a good, flexible vehicle. You can put a lot of good investment types inside of a Roth IRA. You won't be constrained to the company retirement plan menu. So, I think of it as a good, flexible vehicle.

Glaser: You could only contribute to a Roth IRA if you have earned income, but do you actually have to put that earned income into the Roth IRA or could a grad do something like gift money in order to fund that account?

Benz: That's a great point, Jeremy. A lot of new grads do find themselves with graduation gift cash sitting around, and a great use of those funds is to stash it in a Roth IRA. So, even though you do need to have earned income to make a Roth IRA contribution, it doesn't matter where the money comes from that actually goes into the Roth IRA. So, for example, if you earned $2,500 from your part-time job, in 2016 you can make a Roth IRA contribution of up to $2,500, but it doesn't matter where the money comes from that actually goes into the Roth IRA.

Glaser: Another tip you have is that new grads should embrace risk versus shunning it. Why is this the time to take on some more investment risks?

Benz: The key reason is that young investors do have very long runways until they will actually be needing to tap their money in retirement. So, they have very high risk capacities. And that means that because they have a long time until drawdown, they want to reach for the asset class that over very long periods of time tends to have a higher return potential than other asset classes, and that's equities. When we look over market history, equities have generally outperformed bonds and they certainly will outperform cash over a 20, or 30, or more time horizon.

So, we've seen some data indicating that young investors have been perhaps influenced by the negative experiences that older adults around them have had. We had the bursting of the dot-com bubble in the early '00s. More recently, we had the financial crisis as well as a crisis in the real estate market here in the U.S. There has been some indication that younger investors are investing pretty conservatively. In my view, they need to remember the distinction between risk tolerance--how they feel about taking risk--and risk capacity--their ability to withstand the volatility that accompanies stocks. Young investors have very high risk capacities.

Glaser: An option here, of course, would be target-date funds, which would automatically give you a lot of risk upfront and then dial that back over time.

Benz: They can be a really terrific choice because one thing we know is that investors have difficulty figuring out what is the right asset allocation given my life stage and how do I make that more conservative over time. What young investors will find if they reach for a longer-dated target-date fund, is that most of those funds are very aggressively positioned for young investors and they get more conservative over time, but they start out pretty equity-heavy. That's the right allocation for young investors.

Glaser: Another advantage of the target-date funds is diversification, and you warned new investors and the new grads against trying to be too specialized too quickly.

Benz: Yeah, anecdotally, one thing I see in talking to young investors when they tell me about their investment portfolios, some of them are overly focused, in my view. So, they might start with a handful of individual stocks and certainly, it's hard to argue with owning individual stocks as a way to get to know the market, as a way to kind of figure out what you're doing. But there are risks if you have a pretty limited portfolio, if you don't have a lot of money to invest, by packing too much into just a handful of stocks or maybe using some sort of narrowly focused fund, whether it's an emerging-markets fund or a sector fund of some kind, the risks and the volatility associated with such a portfolio tends to outweigh the benefits.

So, I think investors who are just starting out should go very broad, at least initially and then maybe work themselves into more specialized investments as the years go by. But it's hard to argue with a target-date fund, which you mentioned, or perhaps just a good globally diversified equity portfolio of some kind, maybe you're talking a total U.S. market index fund and marrying it with a total international stock market index fund. But the bottom line is that you're getting a lot of diversification in a single shot, I think that's a great way to start out your investing career.

A version of this video appeared in June 2016.