Funds for Recent College Grads

It's never too early to start investing.

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Now that you're heading into the real world, it's time to begin planning your financial future. Saving money might not currently be your top priority, but you'll see a huge payoff down the road if you get started early.

Before you start putting money away, though, make sure you have some emergency cash. Norm Mindel, managing partner at Forum Financial Management in Chicago, says recent grads should make sure they have at least enough cash on hand to cover four to six weeks' worth of living expenses, just in case the job search lasts longer than expected. Next, it's time to start thinking about investing. Mutual funds and exchange-traded funds offer a simple—and often low-cost—way to gain diversified exposure to different types of companies, industries, areas of the globe, and asset classes. Here are some tips for getting started.

[Use our Mutual Fund Score to find the best investments for you.]

Make sure you're diversified. Asset classes like stocks and bonds behave differently, so you should have a mix of them in your portfolio. The idea is that if one slice of the market isn't performing well, another might help offset your losses. Within large asset classes are other categories, such as the stocks of small companies and those of large companies, which tend not to move in lockstep (although if the broad market takes a big hit, both will likely suffer). You should have both large and small companies in your portfolio, as well as a range of industries represented. And don't forget about international exposure and bonds.

During the so-called "lost decade" for stocks, 2000 to 2010, the Standard & Poor's 500-stock index—which holds stocks of large, well-known companies like Coca-Cola and Exxon Mobil—returned virtually zero. That makes the case for a diversified portfolio, Mindel says. "It was only a lost decade if you only owned the S&P 500," he says. If you held other asset classes like small-cap stocks or bonds, your overall returns were better.

[See How to Pick the Best Index Fund.]

The case for stocks. Recent grads have an advantage that many investors wish they still had: time. When you have decades of investing ahead of you, say 30 or 40 years or more, your account has more time to grow and compound interest has plenty of time to work its magic. Historically, Mindel says, inflation can impact your portfolio a rate of about 4 or 5 percent every year, which makes investing substantially in stocks particularly important.

"If you have a long time horizon, the new grad should be mainly in stocks to take advantage of that long-term compounding," says Christine Benz, Morningstar's director of personal finance. "While stocks aren't at the rock-bottom level they were at a year ago, I think we're still going to look back on this period as a great time to start investing in stocks."

All-in-one funds. Premixed funds such as balanced funds and target-date funds offer instant diversification without the hassle of having to choose your own lineup of funds. Vanguard STAR, for example, invests in 11 of Vanguard's stock and bond funds, including Vanguard Long-Term Investment-Grade bond fund and Vanguard International Value stock fund. STAR, which has returned an annualized 5 percent over the past decade, is Vanguard's only fund that will let investors in for $1,000 (all others require a $3,000 minimum investment).

[How to Kick-Start Your Portfolio With Just a Little Cash.]

Other fund companies will waive minimums if you agree to contribute regularly. T. Rowe Price offers more than 90 funds that require nothing upfront—just a commitment to set up an automatic contribution of at least $50 per month. T. Rowe Price Spectrum Growth Fund, which has gained an annualized 3 percent over the past 10 years, has broad exposure to the market with 11 underlying T. Rowe Price stock funds. Many fund families offer a range of target-date or lifecycle funds, which gradually shift their allocations between stocks and bonds as an investor nears retirement. Mindel suggest that recent grads consider target-date funds with horizon dates of 2035 or 2040, which will offer an aggressive allocation to stocks. "One of the advantages of being able to use these asset allocation funds is that you can wind up with five to 10 different asset classes," Mindel says.