Starting Your Kids in Investing with Mutual Funds

One of the best gifts you can give your children is a small investment account when they leave the house. If you can start them out with a portfolio of maybe $10,000 to $20,000 in stocks, they will have the money for a down-payment on a house when they are ready and money to draw upon as needed. By starting them in investing, you are also making it more likely that they will become lifelong investors. This in turn will lead to financial security in their lives.

Believe it or not, building an investment account of such a sum for them is really not as difficult as it may seem. When they are born you also have 18 years until the time they’ll be an adult. If you are able to average around 10% from the investments, that is enough time for the funds to double almost three times. This means that an investment of just $2000 may be worth around $16,000 by the time they are going off to college. Of course if the market does very well, as it did in the 1980’s, the account may be worth a lot more. If it doesn’t, like in the 1970’s, it may be worth a bit less.

Obviously the first step is finding the money to fund the account. Most mutual fund companies require minimums of $5,000 or more. Vanguard, which is one of the better companies for small investors, requires a minimum of just $2,500 for many of their funds. If you have received a lot of monetary gifts for the new baby, consider putting these away into a mutual fund rather than spending it all on baby stuff.

Once you’ve saved up enough money to meet the account minimums, select one broad-based mutual fund and set up a custodial account for your child. You are looking for a fund that invests in a large sector of the market, rather than a fund that is concentrated in any one area. You are also looking for a fund with low fees and expenses since the difference in fees and expenses is typically what makes the difference in performance for funds over long periods of time. You may consider an index fund, which typically has the lowest fees of all. Avoid funds that have large fees for purchases or redemptions.

When selecting a mutual fund, avoid the temptation to pick a fund that has done well over the past year or the last several years. While it is tempting to pick a winner and assume you will get similar returns during the next several years, a fund that has done well may actually lag behind others over the next several years since the stocks it now owns have already gone up in price.

After the initial investment, try adding to the fund during the first few years as you can. Perhaps add some of the birthday money received (you’ll find that they quickly have plenty of toys and clothes are outgrown almost instantly) and some extra funds you have. Don’t worry too much about how the fund performs during any given year- there will be good years and bad years. Trying to time the market by jumping in and out will normally result in poor performance. If it helps you psychologically, save up money and invest more during dips. The important measure is how the fund did versus the return of the market. If your fund consistently underperforms its market segment by several percentage points, say over a period of three years or more, you should think about switching to a better fund.

Once the fund has built up to a substantial size (say maybe $10,000), you may consider selling some of the fund shares and buying another fund to increase your diversification. For example, if you have a large-cap fund, you may consider selling half and buying into a small cap fund. Be aware, however, that the sale may well result in capital gains, which may then require a tax return be created and perhaps taxes be paid.

Maintenance of the account is fairly easy. As stated above, once the account becomes large, or if you move funds from one mutual fund to another, it may be necessary to prepare a tax return – check with your accountant for the minimums. If you do not move things much, however, and the funds you select do not generate many dividends or capital gains, this may not be necessary.

Once your child turns 18, they will then have full control of the account. You have no choice in this. Well before that point (perhaps starting when they are around 10), it is important to start explaining investing to them and let them follow their account. By watching their account grow, they will (hopefully) realize that by leaving the account alone, they can have their wealth grow.

You can explain to them, for example, that if they just spend some of the gains, rather than selling all of the shares and using the principle, they can both have money to spend and the original money. Each year, show how much their account balance increased and how they could take some of that increase and let the rest remain to purchase more shares. On down years, show them that they can purchase more shares at the lower prices and be in even better shape the next time the shares rise in price.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

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