Bad money advice for new college graduates

Source: from Jonathan Clements of wsj.com

Johathan Clements claims that many people give bad financial advice; however, his suggestions are also bad too - at least they will be too sophisticated for new college graduates.

1. AMASS CASH

According to some financial experts (such as Dave Ramsey), your top financial priority should be amassing an emergency reserve equal to six months of living expenses, with this cash saved in no-risks investments like money-market funds and certificates of deposit.

This is dull, unrealistic and not all that sensible. Even if you regularly sock away 10% of your after-tax income, it might take 4 years or so to amass six months of living expenses. At that juncture, you are supposed to leave this money in low-risk investments, where it will earn modest returns for the rest of your life.

Sound bad? It gets worse. While you were building up your emergency reserve, you were likely neglecting important goals like funding your 401(k) plan, which might earn you a matching employer contribution, and saving for a house down payment.

My (Jonathan Clements) advice: Forget the emergency reserve. Instead, contribute at least enough in your 401(k) to get the full company match. Next, fund a Roth individual retirement account. If you still have extra money to save each year, by all means stash it in conservative investments in a regular taxable account.

If you get hit with a financial emergency, tap the money in your regular taxable account first. But you could also borrow from your 401(k). In addition, at any time, you can pull out your Roth contributions -- but not the investment earnings -- without paying taxes or penalties.

My comments - Still, people have large credit card debts often because they don't have any emergency reserve. At least you should build a "beginner" emergency fund if the full emergency fund is a challenge for you. Borrowing from your 401(k) is too sophisticated for new college graduates.

2. BUY BIG

Buy the biggest house possible.

Borrowing a huge sum to purchase an unnecessarily large house is financial foolishness. You will saddle yourself with hefty monthly mortgage payments and a lifetime of large utility bills, maintenance costs, property-tax payments and home-insurance premiums.

Rather, when buying that first home, you should strive to purchase a place that's the right size for you and your family -- and that you can see living in for a good long time.

My comments - A better question is whether you should rent instead of owning a house. New college graduates often will change jobs a few times before settle down.

3. GET A LIFE

Insurance agents often push people in their 20s to buy cash-value life insurance, arguing that it's far cheaper to purchase these policies when you are young.

Don't do it. Remember, the principal reason to buy life insurance is to protect your family - and you may not even have a spouse, let alone kids. And if you are married with young kids, you no doubt need a heap of coverage. The cheapest way to get that coverage is with term life insurance, which offers a death benefit and nothing more.

4. GO FOR GROWTH

People in their 20s are encouraged to invest heavily in stocks, because they have decades until retirement and thus plenty of time to ride out market declines. This is good advice only in theory.

In practice, I would be a little cautious. You don't want to invest heavily in stocks and then panic and sell during the next market plunge. Yet that's a real danger if you are new to the market and you have never lived through a market decline.

My suggestion: Start with 60% stocks and 40% bonds. If you find yourself unperturbed by market swings, move your stock allocation up to 85% or 90% after a year or two.

Younger investors are often also told to favor high flying growth stocks. Growth stocks can be wild short-term performers - but the hope is that they will deliver superior long-run returns.
Unfortunately, there's a good chance this hope won't be fulfilled. Academic studies suggest the highest returns are earned not by growth companies, but by prosaic bargain-priced value stocks.

I am not, however, suggesting you load up on value. Instead, start by building a well-diversified portfolio that includes both growth and value stocks, as well as offering exposure to the broad U.S. market and to foreign markets. If you later want to add a tilt toward value stocks, be my guest. But your top priority should be broad diversification.

My comments - Your portfolio should be broadly diversified - by investing regularly in stock index and bond index mutual funds.

Start with 60% stocks and 40% bonds. Move your stock allocation up to 80% only after you've experienced at least one market correction and you're not perturbed by it.