Teaching Kids How To Invest
According to Gallup poll conducted in late 2015, most people are financially illiterate. The majority of us received no formal education in personal finance during school. We were just expected to figure it out once we entered the real world. Today, many schools are beginning to include personal finance classes as a part of the curriculum. However, as I will illustrate below, the benefits of classroom financial education are largely ineffective. As a parent, you may ask yourself, what can I do help my child? Today we’ll begin a recurring series in an effort to equip parents with the knowledge and tools they’ll need to educate their children about money. Since this is going to be a big subject, we’ll just tackle one piece at a time. Today the focus will be on teaching kids how to invest.
Teach Your Kids by Doing, Not Telling
Think about how your kids learn to play sports. Specifically, let’s look at learning how to kick a soccer ball. You could look up a detailed, step-by-step description of how to kick a ball properly:
Look up to get a read on your target; look to the ball; begin your approach; place your foot vertically even with the ball and an appropriate distance from the ball horizontally with toes aligned to where you want the ball to go; bring your kicking leg back to create a ‘V’; lock your ankle; keep your body straight; bring your leg down to strike the ball with the ‘proper’ part of your foot; follow through with your leg and then body.
Would you simply give your child these instructions and then expect him to kick a perfect soccer ball? Of course not. They need to physically do it in order to understand and improve. The same philosophy applies to teaching kids how to invest (and personal finance as a whole). You can lecture them on the benefits of investing or even put to use some Monopoly money to try and illustrate your points, but until they have some actual skin in the game, investment concepts are not going to stick.
I just want to acknowledge that the irony of this article being an exercise in telling (not showing) is not lost on me. But, my medium is a few hundred words on the internet, so it will have to do.
The Problem with Actually Investing Your Child’s Money
Perhaps what I laid out makes sense and your first thought is “Okay, I will invest my kids’ money in the S&P 500, that way they can experience first-hand what the effects of investing are.”
The problem we face is markets don’t always move the way we want them to. Kids are not going to have the patience and understanding of long term investing with an element of risk. If you were to take $100 of your child’s hard earned money and invest it resulting in a loss of 10% for a year, how do you think your kids will feel about investing? They’ll never want to invest again.
What about a savings account with consistent, positive interest? Our goal is to illustrate investing, not a bank account. We want to show both the risks and rewards of investing. By simply using or imitating a savings account, you may set your child up for a lifetime of “investing” in CD’s and savings accounts, to their detriment.
The Mutual Fund of Mom & Dad
Here is your answer to teaching kids how to invest while avoiding the pitfalls of actual investing. You’re going to start your own special mutual fund. You will custody your child’s money, but not actually invest it. Instead, you will take their balance at the end of every quarter and credit it based on the performance of the S&P 500, but with a couple safeguards to ensure a positive investment experience.
Year 1: We want to make sure things start off right. For the first four quarters of their participation in the Mutual Fund of Mom & Dad, you will apply a performance floor of 0%. You will also add 2% to whatever the S&P 500 does. So, if the S&P returns 6%, your child will get 8%. If the S&P returns -5%, your child will get 2% (0% floor, plus 2%).
Year 2: Get rid of the 2% bonus. Now set a downside limit of -1% in a quarter, but do not allow them to lose for consecutive quarters. If the S&P 500 returns -4% and then -2% in consecutive quarters, their return would be -1% and 0%, respectively.
Year 3 on: Set a downside limit of -2% in a quarter, but otherwise they are participating fully alongside the market. By this point, they will have had a two-year history of likely very profitable investing. This should be enough to emotionally weather some downside, should it occur.
Obviously, this is going to require some basic book-keeping on your part. I didn’t say that teaching kids how to invest would be without effort. It is important to make sure you are keeping accurate records. The last thing you want is your child to feel cheated (though, maybe that is appropriate preparation for adulthood if you aren’t using a fee-only, fiduciary advisor).
Some of your kids might end up being pretty savvy, and the goal of the Mutual Fund of Mom & Dad is not to cause Mom & Dad to go bankrupt. So, the Mutual Fund of Mom and Dad is only available to members of your household under the age of 21 and has balance limits that you feel are appropriate.
Use these tips to get started with teaching kids how to invest. If you’d like to discuss more strategies to educate your kids about money, sign up for our blog below or give us a call to chat some time.