Day Three and we are turning our attention to investing. In particular, what are the different kinds of common investments, how do they differ, and why should someone want to purchase them?
As we take on these topics, don’t be surprised if your children have questions about current events and happenings in the markets. As parents, it easy to think that they don’t really pay attention to the things overheard on the news or the passing comments we make in adult conversation.
However, just this week I was speaking with someone who’s six year old started asking why cows weren’t valuable any more…they had overheard comments about the stock market decline, and being raised in a good Texas home with older siblings involved in FFA, they tied “stock” to “cows”. Our children hear more than we notice and often more than we want them to hear, but this is a great opportunity to provide some clarity on this topic.
As always, the goal is not to turn your children into immediate financial experts, but to provide basic understanding and give space for open dialogue on the basic subjects.
day 3 - The Basics of Investing
Goal: Teach the various common types of investments and highlight the concepts of interest rates and compound interest.
I. What is a Stock? - Stock is a portion of ownership in a company. Each unit is called a "share" as it represents a share of the perceived value of the entire company. Stocks are usually bought or sold 100 shares at a time, which is called a "lot."
When buying stock, one wants to buy when the price is low and then sell when the price is higher due to company growth, success, or perceived value. Most stocks are commonly bought and sold at a stock market through a third person or entity. There are several such markets around the world, but the two largest are in the United States. They are the New York Stock Exchange and the NASDAQ which trade stocks for nearly 6,000companies.
The price of a stock can change a lot over time, even in just one day. Price is based on a number of different things including company profits, projected profits in the future, news about the company, events happening throughout the world, and views of the overall economy.
This may seem a bit complicated based on the age of your children, but walking through some current examples will help them better grasp both current events and how stocks are valued. First , talk about why the markets dropped due to fears around COVID-19, concerns about unemployment, and the belief that most companies profits would be down during the next few months because of these factors. Then choose three different stocks from different sectors and discuss why the price may have acted certain ways recently. You don’t need to get overly technical or even be 100% correct in analysis to help them think critically about this topic.
For example: Netflix (NFLX) - Price fell a lot when COVID-19 crisis started, but has come back a lot more than many other stocks. The reasons are many but include increased demand and potential profits because people can’t go to the movies and are stuck at home. United Airlines (UAL) – Price has not recovered since COVID-19 started as people are not allowed to travel much and therefore profits are down.
II. What is an Index? A market index is a group of company stocks that represent a segment of the overall market. The value of all the stocks selected are used to represent how that segment of the market is doing. There are many different indexes, but three are most commonly used.
Each of these indexes contain different stocks and are calculated slightly differently, but are all seen as general indicators of how the overall stock markets are doing.
III. What is a Mutual Fund? A mutual fund is a collection of many different stocks that are evaluated, bought, and sold by a mutual fund manager. Instead of buying shares of each different company in the mutual fund, the investor buys shares in the mutual fund along with thousands of other investors. This allows the average investor to have access to ownership of a wider variety of stocks than they could usually do own their own. We will discuss why this concept is important in a few minutes.
IV. What is a Bond? When buying a stock, the investor actually owns a potion of the company that issued the stock. A bond does not involve owning part of anything, but instead is loaning money in exchange for interest paid on the loan. There are many different types of bonds and they can come from companies as well as different levels of government.
V. What is Diversification? You have probably heard the saying “Don’t put all your eggs in one basket.” This just means that you can’t put all of your hopes in one thing working out as you desire. When investing, this is called diversification.
We talked about mutual funds earlier as being many different stocks. This is one type of diversification. By owning several different stocks, one can decrease the risk tied to any one stock performing poorly. In addition, diversification can (and generally should) involve a mix of stocks, bonds, and other investment types.
This one may take some time, but could be a lot of fun. Consider setting up mock portfolios for your children using a program like Virtual Stock Exchange at www.Marketwatch.com and monitoring it for a month. If you have multiple children, make it a contest to se who can perform the best. The winner gets to choose where to the family eats when all the restaurants open back up.
VI. The Power of Interest - Very basically speaking, interest is nothing more than a return on investment. If you incest $100 and end up with $110, you made $10 of interest. And what happens when you reinvest the original money along with the earned interest? It just adds to the stack. Doing this repeatedly over time is called Compounding Interest.
Over time, choosing to compound interest leads to a much higher total return in the future. The following chart shows two examples. In one, Billy invests $2,000 a year for nine years early in life and then just keeps reinvesting the interest earned each year. Bobby starts investing $2,000 a year at the same time Billy stops and does so for the next 36 years. Assuming they are the same age, both take no money out, and both make the same return each year, who has more money at age 65?
While it can be fun to think about the power of interest when investing, it is important to know that he power of interest can work against us just as easily when take on debt. For example, if you ran up $14,000 of debt on a credit card and paid only the minimum monthly payment, it would take 24 years to pay it off and that $14,000 would actually cost nearly $30,000!!! Even paying nearly $500 a month would still take three years to pay off and cost an extra $3,000 or more.
This does not mean that debt is always a bad thing. Sometimes it is unavoidable. However, whenever possible, save for larger purchases instead of using debt, and when using debt, try to do so on things that will grow in value over time at a rate at least equal to the debt interest.
Tomorrow, we will tie some of these concepts together as we talk about having a good plan to get where we want to be in life.