Some financial lessons for recent graduates

By David K. Randall

updated 2:28 p.m. ET June 18, 2009

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.

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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.

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