Providing financial education to kids can seem like a daunting project during times of economic stability. Factor in the extreme market volatility we’ve seen during the COVID-19 pandemic, and even the basic tenet of “buy low, sell high” becomes complicated to explain. Financial downturns do present unique opportunities, however. Here we discuss ways to impart sound investment strategies to your children that they can use now and in the future.
Are Your Kids Ready To Learn About Investing?
The first question to ask yourself as a parent is if your child is ready to learn about investing. A key consideration is if your child has mastered the arts of saving and wise spending habits. These two skills create the bedrock of financial literacy and financial success.
Do They Have At Least A Five-Year Investment Horizon?
- If you’re confident that your child is financially savvy enough to manage expenses and capture savings, then the next point to evaluate is if your child’s savings hold at least a five-year time horizon before being needed. Critically discuss with your child if the savings might be needed for significant expenses such as college tuition, a car, study abroad, rent, or anything else within the next five years. If the answer is yes, then secure savings such as cash, savings accounts, money markets, CDs or perhaps high quality bonds are the best choice rather than stocks which run the risk of potentially losing money. Conversely, if the savings won’t be needed for at least five years, investing in stocks provides an opportunity for gains over the long term. Just make sure your child understands that the investments they commit today might need to stay invested for at least five years which can be a long timeframe for a teen or young adult to fully appreciate.
Key Points To Discuss About Investing In Stocks
Educate your child about investing in the stock market. Teach them the basics of risk vs. reward, stocks and bonds, compound returns and the benefits of diversification.
- Risk vs. Reward
Begin by helping your child understand one of the most important factors of investing: risk vs. reward. Risk is the possibility that an investment loses some or all of its value, while reward is the gain that an investment earns over time. The risk/reward tradeoff states that the potential return rises with an increase in risk. Generally, the higher the potential return of an investment, the higher the risk, and vice versa. However, there is no guarantee that you will receive a higher return by accepting more risk.
While stocks can generate greater returns over time, they are also inherently far riskier than bonds, CDs or cash. Stocks can be volatile, fluctuating sharply, particularly during periods of financial uncertainty such as during COVID-19. Since the onset of the coronavirus, we’ve seen stocks lose more than 10% in a single day. You and your child should be prepared for such possible losses before making any investments.
- Stocks and Bonds
Stock investments represent partial ownership in companies and are purchased with the goal of participating in the future potential prosperity of the companies. The more profitable a company is, the more its equity (total value of the company’s assets minus its debts) is worth. Stockholders benefit from that increase in value because the price of their stock shares should also rise. If a company does not need all of its earnings to pay expenses or to grow the company, it might pay dividends to its shareholders.
Stocks have typically rendered higher returns than bonds, CDs or other investments over long periods of time.
With bonds, you loan money to a corporation, municipality or government. They pay you semi-annual interest at a fixed rate to borrow your money. At the end of the term, when the bond matures, they pay you back your principal (the full amount of money you loaned them). If a company goes bankrupt, the company owes their bondholders any amount that it is able to pay (if any) before the company can give any cash to their stockholders. Thus, bonds carry a lower risk and but offer a lower return as well.
- Compound Investment Returns
To demonstrate the power of compound returns, study an investment return calculator with your child. The best way to accumulate large sums is to start early due to the power of compound returns. Let’s say your child was able to invest $3,000 for 15 years and achieved an average annual return of 7%. Their initial investment would grow to slightly over $8,500. The earlier your child starts investing his or her money, the greater the rewards are later.
- Ways To Explain Growth And Risk
Sometimes graphics can convey a message better than words can. Look at a chart of the historical returns for the S&P 500 Index with your child. The growth over time is astounding. Another great lesson from the chart is to look at periods of rough patches, subsequently followed by periods of renewed growth. Long-term investing means sticking with your investments over good times and bad. No one enjoys watching the value of their investments go down, but charts can demonstrate how patience and long-term investing can pay off.
If you have a 529 Plan account set up for your child (and are willing to share that financial information with them) show them a copy of a recent statement. College savings are very relevant to teenagers. Show them your investment returns over the years. A breakout of the amount contributed vs. the current value of the account, as well as how long the account has been open, should be very enlightening.
- Psychological Preparedness
A winning investment strategy is to buy stocks when they’re low, not when they’re high. However, investor psychology runs counter, where people want to buy stocks when they’re high (to enjoy the growth that others are partaking in), and then sell stocks when they’re low (due to fear of loss). If you’re going to invest in stocks, you need to be psychologically prepared to experience losses, and keep your long-term financial goals in mind. If a stock loses value and then you sell it, you’ve locked in that loss, and you might permanently impact your investment psyche for years or decades to follow. We certainly saw this happen with many young investors post the Great Recession of 2008. Many are now fearful of investing, perhaps hindering their long-term financial success. Make sure your child is prepared to experience losses, even if temporary, as one thing is certain about stocks: they will always move both up and down.
- Diversification
Finally, we strongly encourage all investors to employ diversification when buying stocks, where you own broad exposure to many stocks, not just one or a few. Picking a great stock can be rewarding, and we certainly understand the benefit of a child watching the potential growth of a company they love. However, owning individual stocks increases your investment risk, particularly during periods of extreme volatility. The sad reality of COVID-19 is that some companies will survive and some will go bankrupt. If you buy individual stocks, you have to be willing to assume such risks, knowing that any one investment could lose all of its value.
A diversified portfolio comprised of at least 100 stocks helps to reduce your investment risk exposure to any one company. Recognizing that few teenagers are prepared to pick and monitor this many stocks, we recommend buying diversified investments such as index investments (i.e., the S&P 500) and actively managed mutual funds (where a professional investment manager is picking stocks).
Many of these investments still give you ownership in your favorite companies, such as Amazon, Disney, Facebook, Google, Nike, Starbucks, etc., but with less risk to any one company’s performance.
Tim Connolly 