Investing For College Student

Reader Question

Hi, I'm a student looking to start investing with money saved up from part time jobs. What's a good way to get started so that I can save wisely to retire early. Should I invest any differently during college vs after? Thanks

My Reply

Good thinking starting to save and invest at an early age! That goes triple if you want to retire early -- a lot of things have to go right for that to happen, but short of winning the lottery investing early and often is an absolute must.

First off, what should a college student invest in? The answer here is exactly the same as for everyone else: broadest possible diversification of both stocks and bonds at lowest possible cost and with maximum tax efficiency. That last part is less appreciated than others, so make sure to read the link. Broadest diversification at lowest cost invariably means index funds, either in the form of ETFs or mutual funds (mutual funds are simpler for a beginner and probably preferable for most people). Far and away the most trustworthy provider of such investments through decades has been and continues to be Vanguard. There are a few other choices, with Charles Schwab ETFs being most competitive, but I would still go with Vangurd, based on their history and their non-profit structure.

Vanguard has many equally great index-based choices. You could go with Target Retirement funds which start out heavy on stocks and gradually increase bond allocations as you near retirement, LifeStrategy funds which hold the same fixed stocks:bonds ratio for their lifetime, or individual stock and bond index funds -- specifically VTSMX, VGTSX, and VBMFX would be the most important ones -- that you can mix and match to your own liking to achive the desired mix of US stocks, international stocks, and bonds (see towards the bottom of http://www.longtermreturns.com/2012/03/selecting-investment-strategy.html for an example of such mixes). Vanguard has many other index funds as well, but for starters I would urge you to pick either Target Retirement, LifeStrategy or mix of VTSMX/VGTSX/VBMFX. Down the road you could start using some of the others, but you can easily beat 90% of your peers by investing in those dead-simple Vanguard choices your whole life. Target Retirement or LifeStrategy are probably the way to go for most since they are the simplest, while sacrificing very little (namely, a bit of tax efficiency). Personally I have a personal preference for LifeStrategy funds, but, again, you won't regret any of the three choices.

So the decision what to invest in is fairly straightforward. However you should be aware that even more important than deciding what to invest in is the commitment to sticking to it, come what may. It is hugely hugely important to not panic and sell out when things look bad (see 2008-2009) and equally important to not get overly optimistic and risk more than you can afford to lose when things look great (see late 1990s). Investing -- especially investing in stocks -- has always been and always will be a rollercoaster. Just as with a rollercoaster, once you get on, it's a real good idea to not jump off halfway. Pick your mix of VTSMX/VGTSX/VBMFX or pick your one LifeStrategy or Target Retirement fund and stick for it for years or -- better yet -- decades. In those years and decades you will experience many bear and bull markets, hear of countless booms and busts, revolutions, ends of the world as we know it, hot new investments, ways to time the market to buy low and sell high, exclusive investments available to just the select few, hot stock tips, and god knows what else. You will be very wise to ignore every single one of those things and stick to your boring original plan. 99% if not more of them will be utter garbage. Think of them as yet another form of spam, except this one will often come from seemingly intelligent, respected, and eloquent people instead of down-on-their-luck Nigerian princes with access to email. Ignore all of them and stick to your plan.

Besides what to invest in and the commitment to stick to the plan one last thing is exactly what ratio of stocks and bonds to invest in. As you probably know already stocks and bonds are two fairly different, but equally important, animals. Stocks carry a lot of risk with an expectation (but not guarantee!) of ultimately being rewarded for taking the risk. Bonds just kind of sit there, not really moving much either way but paying (unfortunately low in today's world) interest. Picking the right proportions of stocks and bonds is not trivial and the right answer will always be specific to an individual. It really comes down to the need and ability to take on investing risk.

As a college student you can probably afford to take more risk than somebody older. Your future investing lifetime is longer than an older person's which is generally a very good thing since all investments are expected (but not guaranteed!) to grow over time. The longer you can invest for, the more you can expect to have at the end, all things being equal. Even more importantly, you'll have plenty of time to recover from early bad investments. An example might be in order.

Let's say you have $20,000 saved up and you invest it all in stocks and we experience a terrible bear market (see October 2007 to March 2009) and you lose half of that. It'll feel terrible, no doubt, but in reality it'll be an almost meaningless loss. Somebody with a million dollar portfolio -- which, in today's money, is a good low-end target for people aiming to retire early -- experiences a $10,000 loss every couple of weeks. A $10,000 loss might feel absolutely horrible to you because it would represent half of your net worth, but it would just be a sign of your very short earning/saving/investing history. In fact any young person with few investments should welcome such a bear market! It means that your new savings would be buying stocks relatively for cheap, which will more than compensate you for the initial 50% loss over a few years. (Of course the unspoken truth is that a bear market is usually accompanied by tough economic conditions which make millions of lives miserable and make it much harder to have a well-paying job that allows you to save and invest in those beaten up stocks -- so don't get too enthusiastic about bear markets.)

Contrast that to somebody with say, a $800,000 all-stock portfolio looking -- and possibly forced-- to retire next year losing $400,000 in a bear market. Such a loss would be absolutely devastating financially since that person will never again have earnings, will never again be able to buy stocks on the cheap, and worst of all may have to sell his stocks cheap just to make ends meet. Something like that is all but guaranteed to completely ruin the retirement plans (which is why it's a terrible idea to have a 100%-stock portfolio at or near retirement). As a college student you are fortunate to not have to worry about something like this. If you wish to, you can afford to take a lot of risk with your investments and deal with little more than some worries and feelings of regret should the worst happen. That's a small price to pay compared to what our retiree-to-be is facing in the scenario I laid out above.

However though you can afford to take risk with an all-equity (aka stocks) portfolio, it's probably a good idea not to -- for education if no other reason. Bonds (aka fixed income) are a significant and important part of any long-term portfolio -- again just look at what happened to our retiree-to-be due to the lack of bonds. It's a good idea to be equally aware of bonds' existence and importance from the young age so a bad bear market doesn't blindside you down the road. It is absolutely the case that bonds today are priced to deliver mediocre returns at best but, equities are on the pricey side too -- at least the US equities (though not terribly pricey). Having say, a 20% chunk of portfolio in high-quality bonds and the rest in diversified global equities will deliver returns quite close to 100% equities with substantially less pain in the bear markets. Plus it will get you in the mindset of investing in both bonds and stocks which becomes increasingly more important as you near retirement.

So far I suggested you take quite bit of risk with your portfolio. Even a 20% bonds + 80% stocks portfolio should be considered risky. My reasons for doing so are that you are young and wish to retire early -- the former gives you time to recover from early losses and the latter more or less requires that you take substantial risk. But it may well be the case that you know yourself to be a very risk-averse individual, completely unable to stomach even small losses. In this case going with a risky portfolio is a sure way to set yourself up for failure. What will happen sooner or later is a bear market will hit. It will probably start gentle, maybe 10-20% loss over the course of a few months but it could accelerate afterwards (again, see late 2008 and early 2009) to absolutely stomach-turning 5% weekly losses. If you are very risk-averse there's a good chance you will not be able to stomach it and sell out somewhere not far the bottom and, worse, swear off stocks forever afterwards. I've seen it happen countless times, including to those who proclaimed they will hold their investments through thick and thin. It's a very different experience to live through a bear market as opposed to plan for one. So if you suspect or know yourself to be very risk-averse and not be able to weather large losses, then you should plan on holding no more than 50% of your portfolio in stocks. And even a 50% stock portfolio would be no picnic in a repeat of 2008-2009.

Again, only you know how risk-averse you are. Perhaps an 80% stock portfolio -- such as LifeStrategy fund VASGX is the right choice for you. Or perhaps you are quite risk averse, in which case LifeStrategy VSCGX is the way to go. There is no right answer for everybody here, only the right answer for each individual.

To recap:

1. Invest in lowest-cost, broadest diversification, highest tax efficiency stock and bond index funds and nothing else (other than FDIC-insured CDs and US Treasury savings bonds -- both of which are more or less equivalent to regular bonds).
2. Strongly consider Vanguard's products I mentioned above (as well as Vanguard itself as the brokerage).
3. Have an honest conversation with yourself about your need and ability to take risk. Contrast your desire to make a lot as quickly as possible (which is only possible through stocks) with the very real possibility of losing much or even most of your portfolio in a bad bear market (which, again, would primarily affect stocks). If you are still completely unsure, start with something like 40-60% in stocks and 40-60% in bonds.
4. Prepare to stick to the first three points more or less forever. Ignore all bear and bull markets -- there will be plenty of both through the decades. Swear off all the pundits, and gurus, and investing geniuses that you will come across over the years who will tell you all sorts of tales of doom to come or riches waiting for you -- they are all either lying or deluding themselves along with you. If they actually knew what was to come they'd be making billions in hedge funds, not peddling their predictions on TV and the web. Stick to your simple plan for life and you will not regret it.