When children have wisely budgeted their spending to mirror the rankings of importance they placed on various wants, an accumulation of savings should emerge that represents an excess of earnings exceeding wishes that can be realistically fulfilled. This provides an opening to introduce the nuance of investing for the long term. Investing is presented as a path to generate more robust earnings for achieving goals currently out of reach.
Teaching Investment Risk
By the time your child accumulates over a thousand dollars, a savings account has taught that interest was earned for doing nothing. An important lesson to convey is that someone else did something successfully with the money. Wealth is created from inventing, innovating, trading, and building. But these accomplishments require resources in addition to human effort…and resources have costs. The suppliers of money who cover those costs are compensated for doing so.
If the inventors, innovators, traders, and builders fail to provide what consumers value most urgently, effort was wasted and wealth is not created. Providers of money to these ventures are penalized. Teenagers are capable of understanding such risks. The vigilant oversight demanded by investing is no more than that required for survival of common adolescent traumas.
Your parental duty is assuring the risks associated with investing are understood and combating decisions that result in substantial losses. A terrible consequence for young people from investing is holding poor investments too long, resulting in the spurious conclusion that securities markets are rigged against the small investor. In fact, speculative or otherwise ill-advised investment plans are usually the root problem.
Diversification is key to averting significant risk of loss. When only a little money is available for investing, the avoidance of large losses is profoundly important. Needing to sell investments when they fluctuated downward in value is the embodiment of risk. Hence, risk is closely related to volatility, a core characteristic of the stock market. Volatility is manageable with stock mutual funds designed to capture less market downs although coupled with lower advances during market ups.
Tolerable risk also means allocating funds to stocks that will not be needed for spending in immediately upcoming years. A 16-year-old who wants a Ferrari some day has a long time horizon for his money. But he probably shouldn’t put too much of his college tuition money in stocks because he will need to tap that fairly soon. The constructive solution is allocation of some investment capital to fixed income, such as bond mutual funds or exchange traded funds (ETFs). These pay regular dividends from the bond interest they earn. Like any mutual fund, they do fluctuate in value, but diversified bond funds that have been around a long time are managed to mitigate volatile price swings.
For stocks, some fundamental justification for making an investment is crucial before putting money on the line. Among the factors for stock evaluation are the prospects for the company and its industry. Identifying reasonable price starts by examining the ratio of price to earnings. This tells how many years a company must sustain its current annual income for an investor to get back the price paid. Optimism about earnings growth accelerates the payback period. Obviously, mutual funds or ETFs that own stocks provide investor diversification without having to assess individual companies.
Making sound investment judgments is the reward for boldly confronting the risk of investing. As a bonus, investing delivers proof that paying attention in math class really does have benefits.