by Archie M. Richards, Jr., CFP^®
September 27, 2004

John, 27 years old and single, recently started work in Colorado as an engineer. He's setting aside 3 percent of his pay in a 401(k) plan, with employer matching. He owes $30,000 in student loans, and he's looking for his first home. Eventually, he intends to run his own business. John has an extra $3,000 and wonders where to invest it. By the way, he doesn't understand the difference between index funds and mutual funds.

You raise three issues, John.

1. First, forget about investing the $3,000. Yes, I expect the world's stock markets to rise. But somehow I've never figured out how to walk on water. My stock market predictions might be wrong. Don't invest money in the stock market you intend to use within 5 years.

   If your employer provides at least 50 percent matching, go ahead with the 401(k) plan. But otherwise, drop the investing. You already have $30,000 of debt and you're just starting out! To buy a house, you'll have to lay down a hefty chunk and take on a mortgage. Eventually, a new business could require hundreds of thousands of dollars of capital. You'll have debt pouring out of your ears!

   Even before you start a business, what if you lose your job or your employer goes busted? You'll be stuck with huge debt and no income. You may be married and have a child by that time. What would the child eat?

   Concentrate on preparing for your business. Business owners have to know leadership, sales, human relations, negotiation, finance, accounting, not to mention their own field of expertise. Some of these skills may be innate, but others have to be learned.

   Take classes, minimize your expenses, and pay off debt as fast as possible. Resist the impulse to keep up with the Jones's. After your business succeeds, you'll leave Mr. Jones way behind.

2. If you insist on investing the $3,000, use the Vanguard International Stock Market Index Fund. I'm especially optimistic about the prospects of foreign nations.

   Vanguard's IRAs have lower minimums ($1,000), which would enable you to acquire both foreign stocks (see above) and U.S. stocks (see below). But skip the IRA, because you'd pay taxes and penalties when the money's withdrawn to buy a house and start your business.

3. Finally, the difference between index funds and mutual funds.

An index is a measure of an entire stock market or a specific sector of stocks. For example, Dow Jones and Company and Wilshire Associates jointly operate an index of about 7,000 stocks, representing virtually all U.S. publicly-held stocks. Dow Jones & Wilshire don't buy the stocks; they merely keep track of them. As the stocks move up or down by a certain percentage, the index, now standing at 10,838, moves up or down by the same percentage. (This index isn't the same as the Dow Jones Industrial Average.)

The Dow Jones Wilshire Index is not a real portfolio. But Vanguard offers a real fund that tracks the index. It's called the Vanguard Total Stock Market Index Fund. Vanguard doesn't buy all 7,000 stocks. To save costs, it buys only about 3,000 - enough to parallel the index closely. The fund doesn't try to outdo the index; it just tries to do as well.

With no stock research needed, the fund's costs are low (0.20 percent per year). Since Dow Jones & Wilshire seldom change their selection of stocks, Vanguard buys and sells infrequently, saving transaction costs and capital gains.

Some indexes, like the Dow Jones Wilshire Index, are very broad. Others track big stocks, small stocks, growth stocks, value stocks, and stocks of particular industries or foreign nations. Most indexes are tracked by index funds or exchange-traded funds.

But never mind investing, John. Minimize your debt and set your sights on owning a business. Other than getting married, that'll be the biggest deal of your life!

The world's largest Muslim nation, Indonesia, just conducted its first-ever direct election for president. Flocking to the polls, the voters threw out the sitting president because she wasn't tough enough on Islamic radicals. Wonderful news!