Sunday, July 29, 2018

Teaching Our Children About Investments

Average Rate of Return

I think the first thing a child should learn is what is a reasonable investment return.  Once your child has an investment, say a Roth IRA after starting to work and make money, then your child might be surprised that the investment does not skyrocket out of sight.  The article The Market Isn’t Going to Save You From Saving Too Little by James Mackintosh, July 26, 2018, Wall Street Journal, says, "Since 1900, U.S. stocks have returned 6.5% a year after inflation, including dividends, according to academics Elroy Dimson, Paul Marsh and Mike Staunton."


Explain to your child that inflation steals his money.  So if the investment fund says the investment returned 9% last year, and the Federal Reserve claims 2% inflation, then assume the real inflation was at least 3% because the Fed lies about inflation.  Thus a 9% rate of return, minus 3% inflation produces 6% real return, which is like the historical average.

It so happens that the long term average inflation rate in America has been 3.22% per this article:  Long Term U.S. Inflation by Tim McMahon (April 2014).

The Rule of 72

I suggested you teach your children about the Rule of 72 back in April 2015:  Teaching Our Kids About Interest and Inflation.  Now you can point out that 72 / 6% = 12 years for the investment to double.  The investment will grow, but patience is required.  Some other time we might talk about dollar cost averaging.

Safeguarding Savings

I suggest you teach your children to guard their money against losses.  Here is an example I use:  You start with $20,000 in an investment.  It is a risky and volatile investment, so one year you lose 50%.  Now your investment has dropped to $10,000.  The next year your investment bounces back with a 50% gain.  Have you gotten your money back?  Fifty percent down and then fifty percent up, so are you good?  The math says that a 50% gain on $10,000 gives you $15,000, so you are still down $5,000.  It is easier to lose money than to make money in investments.  Investments are a long game. Taking risk for high gains is gambling, it is speculation, but it is not investment.

Hot Shots Like to Crow

I also tell my children that when people they know make a lot of money with an investment, then they might crow about it.  But when they lose a lot of money in the market, they rarely confess their failures.  They will hear plenty about success and little about failures.  Most hot-shot investors profiled in the news eventually run out of luck and hit a stretch of bad luck.  I have steered my children towards mutual funds.  If you do not want to read the book A Random Walk Down Wall Street by Burton Malkiel, you can read the summary of it in Wikipedia.

It is up to us to teach our children!


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