Ordinary Americans –including children– have little choice but to invest in the financial markets if they hope to save for retirement. Their best investment goal is durable earnings (paraphrase from Leo E. Strine, Jr., 20071).
I was glad to learn that my 10 year old granddaughter is interested in investing. Not only that, her parents readily agreed to open a custodial account at their brokerage firm. I may be able to help by giving advice as well as supplying capital! My hope is that she will invest 10% of all earnings until she retires 50-60 years from now. The basic goal of a child’s retirement plan is to beat inflation. Suppose my granddaughter’s annual investment return is 7% and the annual inflation rate is 2%. Her investment return would beat the inflation rate by a margin of 5%. Learn more about starting an investment program by reading Hey Kids in this blog. The following discussion is useful for coaching young investors.
Time
Time and choice are the strongest drivers of retirement savings. The following chart illustrates the advantage of investing in the U.S. Stock Market.
The red line shows payments of $1 per year for a total $51 ($1 is a mere fraction of what any child with an allowance could invest!). If the U.S. Stock Market (green line) returns 7% annually, she could plan on saving $464 by the time of retirement (Market fluctuations are safely ignored). Suppose she doubled her annual investment to $2, she could plan on holding $928 after 50 years, etc. The breakeven point occurs near the 21st year when her retirement savings match her future total payment. Market corrections will affect the trajectory of her savings plan, but she will likely continue earning compounding returns over the long term.
Choice
Securities are investment contracts that generate profits solely by the efforts of other people. Securities are converted to cash in marketplaces where trading generates additional profits and losses. Among classes of securities the young investor has a choice of purchasing cash equivalents, bonds, equities, and derivatives. The best choice among these is stocks or stock-funds.
Cash equivalents are certificates of deposit that act like bonds or money market funds that act like investment funds. The investor can expect to recover the cost plus a small reward in the form of interest or dividends. Cash equivalents are typically short term investments that are not designed for long term use. Don’t expect a series of cash equivalent investments to beat the rate of inflation.
Bonds are certificates of debt that require borrowers (issuer) to pay lenders (investor) the borrowed money (principal) plus interest over a specified time (maturity). Interest is the source of future cash flow to lenders. Investors must consider the credit rating of the borrower, the maturity of the bond, the type of bond, the interest rate, and the extent of periodic trading of bonds (turnover). Many of these factors can be delegated to a professional manager by investing in bond funds. Bond market index funds typically offer steady returns to investors, but don’t expect to beat the rate of inflation.
Equities (e.g., stocks, ETFs, REITs) are shares of ownership in a company that provide shareholder rights to corporate income and capital after the settlement of all obligations to creditors. Stock shareholders typically have voting rights in matters of corporate governance. The investor’s future reward is linked to corporate earnings and dividends. Investors must be skillful in selecting the right stocks to achieve their investment goal. If your goal is to match the performance of diversified portfolio of stocks, consider investing in a stock market index fund. The total stock market index represents the value of all stocks listed in the market. History shows that the total stock market value grew at an annual rate of 7% during the last century, which is enough to outpace the rate of inflation. Investors can purchase shares by opening a brokerage account or buying directly from the company.
Derivatives are contracts between a buyer and seller based on the price movements of underlying assets. Derivatives are complicated, risky investments that are ill-suited for the goal of sustained growth of savings.
Strategy
Simplicity is the key to success. The following advice is based on generally accepted principles of personal finance and the advantage of investing in index funds:
- Invest a dime from every dollar earned2.
- Invest in one stock-index fund3.
- don’t waste time picking stocks
- don’t worry about the stock market
- after twenty years, consider adding a bond-index fund to the portfolio
- Grandchild should learn to manage the investment account.
- Minimize trading fees3.
- reinvest the returns for free (this is how compounding works best!)
- consider selecting an exchange-traded index fund or no-commission index mutual fund
- Avoid taxes by opening a tax-deferred brokerage account as soon as possible (today’s best choice is a Roth Individual Retirement Account).
- Protect the investment from debt, loss of wages, excessive spending, and unexpected events2.
- Seek advice from good books and wise investors2.
Roles
Because I’m her grandfather, I would enjoy contributing to her investment account on special occasions. It could be a cooperative adventure between me, my daughter, and my granddaughter. I would contribute money and collaborate with my daughter on giving advice. My daughter would open and administer the investment account. Hopefully, my granddaughter would learn the habit of saving for retirement and take full control of the process at age 18 years.
Copyright © 2013 Douglas R. Knight
References
- Leo E. Strine, Jr. Toward Common Sense and Common Ground? Discussion Paper No. 585, May, 2007, Harvard Law School, Cambridge. The Harvard John M. Olin Discussion Paper Series: http://www.law.harvard.edu/programs/olin_center/
- George S. Clason, The Richest Man in Babylon. Penguin Books, New York © 1955, .., 1926.
- John C. Bogle, The Little Book of Common Sense Investing. John Wiley & Sons, Inc. Hoboken, 2007.
