As parents contemplate which essential conversations to have with their children, a discussion around savings and investments should be at, or near, the top of the list. It is important for children to have a basic understanding about how the markets work, as well as an appreciation for the power of compounding. And while it may be difficult for your kids to think about saving for an event like retirement that is 40 or 50 years away, these conversations have the potential to be incredibly impactful, as they may instill in them an inclination to save throughout the course of their lifetime. In these discussions, parents would be wise to also talk about diversification and the different vehicles their children can use to save and invest.
While keeping things clear and understandable, parents should explain how markets operate while expressing the ability to build a significant portfolio by starting to save and invest at a young age. Beginning these conversations even before your children have the wherewithal to invest can be effective since they are likely to be intrigued by the idea of seeing an account grow over time. They should also understand that volatility — particularly to the downside — is inevitable for long-term investors; anyone who participates in the market will have to withstand some downturns. However, this is perhaps one of the most profound advantages that younger investors benefit from — an abundance of time and the ability to allow for markets to bounce back, all the while “buying” while they are depressed. If nothing else, a child who understands this dynamic will have the propensity to endure downturns while considering them opportunities to invest.
The power of compounding is also an incredibly important concept for young investors to comprehend. Someone who begins saving $184/month at age 15, and grows their investments at a rate of 7% annually over time, will have $1,000,000 by age 65. If the same individual decides to hold off on saving until age 25, they will need to save $381/month until age 65 (also growing at 7%) to amass a $1,000,000 portfolio. Waiting until ages 35 and 45 to begin saving will require saving more than $800/month and nearly $2,000/month, respectively. The graphic below clearly illustrates the significance of compounding.
What is particularly interesting about these graphs is the breakdown of savings versus growth. At age 65, nearly 90% of the portfolio for the individual who began saving at age 15 is attributable to growth, with the $184/month amounting to about 10% of the $1,000,000 balance ($184/month for 600 months = $110,400). Conversely, just about half of the portfolio for the individual who began saving at age 45 is attributable to growth, with the other half emanating from savings/contributions ($1,920/month for 240 months = $460,800). So teaching children about investment returns, and how compounding over a long period of time can significantly influence account balances, may be a catalyst to save and invest as opposed to spending.
As soon as your children have a general understanding about how the markets work, consider having a conversation about how to best construct a portfolio. Not surprisingly, most children simply think of “stocks” when it comes to investing. And while most or all of their portfolio will likely consist of stocks at a young age, it is important to understand there are many different ways to invest in them. There are large company stocks and small company stocks, domestic stocks (U.S.) and international stocks. Beyond stocks, savers have the ability to invest in bonds, real estate, and commodities, among other options. Not only does this give children a heightened understanding of investment opportunities, it also segues into the importance of diversification.
Most investors, at some point in time, have been told why diversification is important, and it is oftentimes boiled down to the simple idea of not having all of your eggs in one basket. A well-diversified portfolio is critical and will reduce one’s reliance on just one or two stocks doing well. This can be a particularly difficult reality to impress upon a child who learns that Netflix has been one of the best performing stocks during their lifetime. (“Why would I want to own anything else?”) When a portfolio includes various types of investments that behave differently, losses on one can be offset by gains in another.
Again, a well-diversified portfolio should consist of exposure to different types of stocks. Large company stocks tend to be more stable while small company stocks are typically more volatile. However, smaller companies may have greater growth potential. Further, children might benefit from understanding the difference between growth and value stocks. Growth stocks generally grow at a rate that exceeds that of the overall market whereas value stocks are seen as being undervalued (for what could be a variety of reasons), and might therefore be good long-term “plays.” So just as someone might want to have both large and small company stocks, they also ought to invest in both growth and value stocks; simply put you don’t want to rely on just one of these “styles” being in favor forever (as growth has been for some time now). Lastly, a portfolio should also have some exposure to international stocks as they provide an additional layer of diversification.
Now that your child better understands some basic concepts about investing, how do they get started? Many kids may have bank accounts and understand the idea of deposits and withdrawals. Well, the same dynamic applies to a brokerage account; a child or young adult can establish an account and make a deposit prior to investing. But if the child has earned income, they should seriously consider establishing a Roth IRA, and contributing as much as they can each year (up to the lesser amount of earned income or $6,000). Roth IRAs can be an attractive option for younger individuals who aren’t concerned about their savings being earmarked for retirement. Contributions to a Roth IRA are made with after-tax dollars (so the contributions are nondeductible) while growth within the account, provided certain conditions are met, will be tax-free. This is a particularly appealing option for younger savers as tax-free growth throughout the course of 50+ years can be tremendously powerful.
As a young adult entering the workforce out of high school or college, they should also know whether their employer offers a 401(k) and if they provide matching contributions. Although employers are not required to do so, many will match their employees’ contributions to their 401(k), up to a certain percentage or dollar amount. These matching contributions are oftentimes referred to as “free money,” and are sometimes the “carrot” young savers need to begin investing.
Encouraging children to consider the long-term will be challenging, especially given their tendency to seek instant gratification. Doing so, however, is worthwhile, as these conversations will provide them with the tools they will inevitably need to be financially independent. We encourage all parents to have these discussions frequently to reinforce the principles discussed herein. Your children will thank you later.
MAI Capital Management, LLC (“MAI”) is a fee-based registered investment adviser and wealth management firm based in Cleveland, with additional offices in Cincinnati, OH, Ponte Vedra Beach and Naples, FL, Nashua, NH, Irvine, CA, Reston, VA, Little Rock, AR, New York City and St. Louis and a presence in Columbus, OH and Miami.MAI’s Cincinnati office is located at 625 Eden Park Drive, Suite 310, Cincinnati, OH 45202. For more information, call 513.579.9400 or visit www.mai.capital. The opinions and analyses expressed herein are subject to change at any time. Any suggestions contained herein are general, and do not take into account an individual’s or entity’s specific circumstances or applicable governing law, which may vary from jurisdiction to jurisdiction and be subject to change. Distribution hereof does not constitute legal, tax, accounting, investment or other professional advice. Recipients should consult their professional advisors prior to acting on the information set forth herein. In accordance with certain Treasury Regulations, we inform you that any federal tax conclusions set forth in this communication, were not intended or written to be used, and cannot be used by any taxpayer, for the purposes of avoiding penalties that may be imposed by the Internal Revenue Service.