How should a college student invest her funds inside a Roth IRA?
My daughter is opening her Roth IRA with $3K. She is 19 years old and in college. Where is the best place to put her money? We were thinking Target date funds, but we could use some advice.
Your daughter has a very long investment horizon and should be able to bear some risk. I'll assume this is her first investment and there are no other assets. $3,000 is a starter portfolio so you should be cognizant of costs like commissions. I would recommend one position, a stock index fund, for now. Vanguard's target date fund for 2060 is 90% stocks anyway and the target date structure adds a bit of cost. Additionally, as she starts saving her own money outside the Roth IRA, it get cumbersome coordinating target date holdings with the rest of her portfolio.
Given the amount invested, it makes sense to keep commissions low or zero. You can invest in Vanguard's Total Stock Market index (VTSMX) in a Vanguard account. Schwab has a commission free stock index fund (SWTSX) that you can trade in a Schwab account. Both of these funds give you broad exposure to the US stock market. Fidelity has its own stock index fund on its platform.
Reinvest the dividends and capital gains distributions so idle cash does not accumulate. As time goes on and money is added to account, you can look to other asset classes like foreign stocks or bonds.
Great question in large part because you included your current plan of action with target date funds. Target date funds are the no-thought investment choice for a great many people because they automatically reallocate according to age, which equates to "set it and forget it." While I will not offer individual advice because that should take into account all financial aspects of someone's life, your question seems straight forward and general enough to give you my two cents.
I generally advise people against Target date funds because they consistently underperform the major market indices. The younger a person is and more risk tolerance they have, the more I look at straight market indices. For a 19 year old who has some 40+ years before they can or will use the money, it would be a disservice to put them into a fund that could potentially moderate their risk prematurely. A small cap index could be very appropriate for a younger person or even the S&P 500 or DJI for those younger people with relatively low risk tolerances. There will inevitably be losses along the way, but in this case, the distance of the retirement date makes it overwhelmingly likely that those dips will be momentary over her lifetime.
(Good choice on the Roth by the way- she's probably paying little to no income tax now so taking the bite up front will result in very little, if any, pain.)
I would pick one stock from each of these 3 categories and would invest $1,000 in each:
- A technology company she can relate and use (Apple, Google, Facebook, Netflix.....etc)
- A traditional manufacturing company that produces something that she uses and likes (Procter & Gamble, Coca Cola, Colgate.....etc)
- A diversified Conglomerate (Berkshire Hathaway, GE ..... etc)
She would benefit from such a portfolio in different ways:
1. She will get a better sense of owning a company, she will receive annual reports, she can have a better chance to educate herself about investing (compared to buying an etf and forgetting about it) and the relationship between the products and the value of companies.
2. As the first 2 stocks will be related to the products and services that she is familiar with, she can probably spot important trend changes better than most professionals (like if Facebook becomes out of fashion or her friends stop using apple products...etc) and get out of the stock.
3.She can decide how to use the dividends. She can invest them in the same stock or pick a 4th one and accumulate the dividends there. Once the portfolio reaches $4,000, she can add another stock.
Holding individual stocks can be more risky and especially if you are holding stocks for 20 years, there is a chance that any of the companies you hold may go out of business. But at the same time, there is also a very significant chance that some of your holdings may double, triple, or more in 20 years.
This is of course a higher risk and higher return strategy than buying an ETF or mutual fund, but I believe she will benefit more in the long run by becoming a more savvy investor.
I specialize in young professionals, so your daughter is right in my wheelhouse. Target date funds are good, but I believe they tend to be a little more conservative than need be. My concerns for your daughter are:
1. Being too conservative - she has a lot of time. Upwards of 50 years, possibly longer with life expectancy trends.
2. Can she control the emotions of investing? If the market goes down, will she be strong enough to stay the course?
If she can do these things, then a simple S&P 500 index will work. She can add a small and mid-cap index or even an international for a little diversification. Though, at her age, diversification may be overrated. These are very specific comments and may not be right for her. Please consult someone who would know her situation and goals better. But this should be a good start.
Congratulations on instilling the importance of education, formal as well as personal, in your daughter!
Absolutely, a Roth IRA, in general, is a great place to stash money while your daughter is in the lowest tax bracket she will ever be in. And it doesn't matter where the money comes from as long as she has sufficient earned income to justify the contribution. For example, let's assume she works part time during school and made $3,000 last year. And spent it all on living and school expenses. You can give her money or use her savings to fund the Roth IRA up to $3,000. In addition, she may qualify for the Saver's Credit.
If your daughter plans to make regular, monthly contributions over many years, which is what I would suggest, then I would pick a handful of no-fee DRIP stocks that match her personal and ethical beliefs. Volatility is the friend of steady, long-term investors. But get an advisor to do a historical comparison of your DRIP portfolio versus a highly rated target date fund.
Best of Luck!