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1. Use it as the start of an emergency fund. An emergency fund is three to six month’s worth of expenses in a bank account, typically 6,000-$15,000, that you keep around to pay for things like emergency car repairs and unexpected medical bills. Once you buy a home, it can help cover the air conditioner that breaks suddenly and other emergency home repairs as well (although you should also be saving up for these sorts of things that happen suddenly but are predictable to happen eventually). It is money that keeps you from pulling out the credit card and going into debt at 18% interest whenever life throws you a curve. It is also money that you can use if you lose your job while looking for another one. It should be replenished as fast as possible when you need to dip into it – before you go on vacations or even go out to eat – because it really needs to be there when you need it.
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If you’re going to college and your parents will be there to back you up, at least for a while, you won’t need much of an emergency fund. Something on the order of $500 to $1000 to allow you to float an emergency car repair or class fees you weren’t expecting until you can get reimbursed by mom and dad should do it. That means that maybe $1000 is all you’ll need in a bank account with easy access via a debit card, leaving you able to invest the rest. If you don’t have your parent’s backing, you should start saving up enough money to pay rent and for all of your other necessities for a couple of months in case you lose a job, so your graduation money can give you a head start on this. This will also allow you to cover the random big expenses that happen without going into debt. You won’t need to have as much saved and ready as you will later in life because jobs you’ll have as a college student/young adult will be easier to replace than those you’ll have later, but you should still have some money ready.
With any extra money from graduation beyond what you need in cash, you can invest to increase your returns and grow your stash. This will also serve as an emergency fund since most of the time you’ll be able to sell some stock and tap it if needed to pay for things. But there is a risk that the markets will be down right when you need the money, hence, the need to keep some money in cash. If you had $2500, you could buy shares of an ETF such as the SPDRs (S&P500 fund, pronounced “spiders”) or the DIAs (Dow Jones Industrial average tracking fund, pronounced “Diamonds”). To buy the ETF you would need to go through a broker, which isn’t hard to do. You can setup an account with a broker like Schwab or Robinhood in just a few minutes through their website. With $500 more to add to the $2500, you could buy index mutual funds such as an S&P500 fund through Vanguard or another fund company.
During college the value of your ETF or fund could go up of down depending on what the market and the economy does – four to five years is a short amount of time for investing in stocks – but by investing in mutual funds you have a chance of growing the value to $4000-$6000 in 5-10 years. You could then sell the fund around the time you start work and put the cash in a bank account as a starter emergency fund, add to it over time from your salary, and then have a fully funded emergency fund that would give you a good measure of financial security within a year or so. If the fund doesn’t do well and perhaps sinks in value (worst cases scenario would be that it was worth maybe $1000 after five years, which would only happen if we had a very serious economic decline like the Great Depression; this is very unlikely statistically) you would just hold onto the funds and build up an emergency fund from your salary. When the fund recovered enough after a few years, you could then sell and top off your emergency fund.
2. Invest it in a mutual fund or ETF as a starter portfolio. A second possibility would be to just put the money away as an investment for the future that you could use as a down-payment on a home or some other expense that will come up down the road. It is also really nice to have a stock portfolio that you can tap periodically to add to your income and enhance your lifestyle. Realize that if you’re able to pay cash for things rather than hitting the credit cards or getting a home equity loan, you’ll be getting a discount (because you’ll be receiving income on the money until you spend it) rather than paying a premium (from interest payments). This means you’ll get a lot more out of the money you earn from work than your peers will by funding their lifestyles through credit. The money you get from graduation can be the start of this portfolio which you could then add to in your career and increase how much extra income you can get throughout your life.
In this case you would invest in an ETF or a mutual fund as before but just plan to leave it invested for a long period of time. With a mutual fund, when you start working you could then add to the position with regular contributions from you paycheck, for example, adding $300 per month. With an ETF it would not be cost effective to invest $300 at a time. Instead, you could just save up each month in a savings account until you have enough to buy a second ETF or more shares of the same ETF. You would do this each time you have enough money saved up to make the brokerage fees you’d pay when you bought the ETF a reasonable percentage of the amount you were investing.
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Really, any index fund or ETF would be fine for a start. A small-cap (small companies) ETF would be a good first choice since you’ll make more money investing in small-caps over long periods of time (like 15-20 years) than you will investing in large companies. As you build the portfolio, you’ll want to have both large-caps and small-caps, along with international companies. You can also add bonds to reduce the fluctuations in the value of your portfolio without reducing your returns very much. The percentage of bonds you include depends on your personal tolerance for the ups (and especially the downs) in the value of your portfolio. A 60% stocks, 40% bonds portfolio is a good ratio for good returns with a relatively low degree of volatility.
Increasing the percentage of stocks will increase your returns a bit, but it will be a wilder ride. Just remember that you only get hurt on a rollercoaster if you jump off, so stay the course and stay invested if things get dark. There is nothing wrong with just ignoring it if you wish during a bear market since there is really nothing to do besides keep investing more.
3. Use the money to start an IRA. Retirement is one of those things where the earlier you start getting ready financially, the easier it is. If you are working at a job so that you are earning an income (a requirement for investing in an IRA), you could invest as much of the money from your graduation money in an IRA as you earn in wages during the year. If you put the money in an IRA and then invests it in a mutual fund or ETF in the IRA, you would go a long way towards funding your retirement before you even go to college. If you can invest $2500 in index funds within an IRA and earn 10% annualized between the age of 18 and 70, which is very possible invested in stocks, you would have $355,107 when you retire at 70 years old just from that first investment. If you can work a few summer jobs in college while staying at home during the summer to avoid rent and food costs, you could invest a few thousand more in an IRA and easily be set to be a millionaire before you retire. The power of compounding is truly astounding!
There are two choices when investing in an IRA. There is the traditional IRA where you receive a tax deduction for the money you put into the IRA. Essentially, you don’t pay taxes on the money you put into the IRA, so if you put away $2000 and are in the 10% tax bracket, you’ll save $200 in taxes. If you can put $5000 away, you’d save $500. The catch is that when you retire and start pulling the money out, you’ll need to pay taxes on the money as if it were income from a job at that point. It will actually be a wash if you’re in a 10% tax bracket when you retire as well, but if you end up with a substantial amount of money in the IRA, it is more likely you’ll be paying 25% or even 40% taxes on the money when you withdraw it.
A second option is to put the money into a Roth IRA. Here you’ll pay taxes on the money when you earn it, but you’ll be able to withdraw the money, including the earnings, tax-free in retirement. This is a very popular option since your taxes are low when you start your first job but are high when you have a big retirement account. The risk here is that you’re expecting the government to keep its end of the bargain. A lot can change in 40 years, and even if they don’t tax Roth IRA withdrawals directly, if they create something like a VAT tax which taxes your spending, you’ll effectively be taxed on your Roth IRA money anyway, so it is a risk. Splitting the money and investing in both a Roth IRA and a traditional IRA is a possibility as well, giving you the best of both worlds. A lot of risk management in finance involves dividing up your money and playing all possibilities. Don’t put all of your eggs in one basket, so to speak.
4. Invest in a business. Many people who buy individual stocks try to beat the markets by trading, where they buy a stock, hold if for a few months, then sell for a small profit. This is a losers game and I would not recommend it. Instead, one option is to buy an individual stock with the money from graduation but do so as if you were buying a stake in a business as a venture investor. You would want to find a company that has a great product, a stellar management team, and plenty of room to grow and expand over the next ten to twenty years. Find one with a Price to Earnings ratio, or “PE ratio,” of less than 20 so you know you aren’t paying too much. You would then buy in with the idea of holding through think and thin, giving time for the company to grow and reach its potential. There is certainly a risk of losing the money by doing this (maybe one in 100 stock picks will go belly-up entirely, while maybe half will just sit there for years and not grow), but $2500 to $5000 is a small amount of money compared to your future earnings and it could grow into enough money to make a good down payment on a house in ten years or so if you pick the right stock.
As with investing in mutual funds, you could also set aside some money from your salary when you start working and buy shares in other companies with good long-term prospects each time you have $1,500-$3,000 saved. You should start to put some money in mutual funds as well as your portfolio grows to protect the wealth you gain and in case you aren’t a good stock picker. Again, cover all bases. By doing so you will build up a portfolio and eventually reach financial independence. If you want help in developing a plan and determining how much you’ll need to be putting away to probably reach financial independence by a certain age, check out FIREd by Fifty. In there I lay out the exact methodology and calculations needed to reach a goal.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.