Teach Kids to Diversify Their Investments

When your child is saving her pennies in a jar, it's probably a good idea to keep everything in one place. This way, she'll see how her savings grow by looking at how high the coins rise in the jar. As your child's savings grow into the thousands of dollars, however, keeping things in one place—especially a jar—isn't the best idea. At this point, your child needs to diversify her investments.

Diversification means putting money into different investments. Maybe your child wants to own stock in Disney, McDonalds, and Apple Computer. Even if Disney goes down in value, this may be offset by increases in McDonalds and Apple. Overall, she's still in good shape financially. In effect, it's hoped that by spreading money around, your child won't suffer too great a loss if one or two investments do poorly.

You and your child must know two key things about diversification: how to allocate assets once her savings account reaches a critical mass, and at what point to change this allocation.

Allocating Assets

If your child has only a few dollars, he's probably going to put it all in one place, such as a bank account. But as his savings grow, he should be thinking about allocating his assets.

As you've seen, diversification is the idea of going into a variety of investments. Putting that idea into action requires some decisions on what's called asset allocation. There are no magic formulas to use in allocating assets for your child, but experts suggest many different formulas for asset allocation. Here are a couple to consider just to give you an idea of how the allocation process works:

• 80 percent rule. Multiply your child's age by 80 percent to find the percentage of his investments that should be in bonds and other fixed-income investments. Subtract this from 100 to find the percentage that should be in stocks and stock mutual funds. For example, using this rule, your 15-year-old should have 12 percent of his total investments in fixed-income (15 — 80 percent) and 88 percent in growth stocks and stock mutual funds.
• 110 minus your child's age. Here, just subtract his age from 110 to find the part that should be in stocks; the balance goes into fixed-income investments. So, your 15-year-old should have 95 percent of his investments in stocks (110 - 15) and only 5 percent in fixed income. Of course, this formula means that any child 10 or under should be entirely invested for growth, which may not be the best course of action.

The problem with formulas is that they fail to take into account your child's personal situation. If he has only a few thousand dollars or less to invest, then these formulas don't make much sense; they're intended for more sizable holdings. Also, if there's only a little money involved, your child is in less of a position to risk any losses.

Formulas also don't take into account other factors:

• How necessary the money is to him. If you can afford to pay for his college, then he's in a different investment seat than someone who's investing to get his tuition together.
• How much risk he can stand. Some people are more inclined to gamble with their money and don't lose any sleep over the ups and downs of the stock market. Others like to play it safe And are only happy knowing that their money is FDIC-insured. It's important to know what kind of risk-taker your child is so that he'll make the investment decisions he's more comfortable with. Of course, you'll want to encourage some risk taking, but how far you push things depends on your child's personality.

Income Versus Growth

Two main categories of investments exist: those that produce a fixed income, and those that go for growth. Fixed income mainly means interest income earned on savings accounts, bonds, and similar investments.

Other types of income relate to non-fixed income investments, such as stocks and stock mutual funds. These two types of income include dividends and capital gain distributions from mutual funds. This income is paid when companies make money and share their good fortune with their shareholders.

Fixed-income investments offer your child certainty. She knows when she buys a fixed-income investment exactly what she'll have when she's through. For example, if she buys a CD paying 5 percent interest for five years, she can figure today to the penny what she'll be paid five years from now.

Fixed-income investments, however, don't offer any possibility that they'll be worth more than expected later on. There's no possibility for growth.

Growth investments, which include stocks and stock mutual funds, are so named because they're held primarily for the chance to have the investment grow in value over time. This growth in value is translated into more money when the stock or fund shares are sold and result in capital gains.

Adults are always talking about capital gains, and this topic is important for two reasons.

• Capital gains are taxed only when something is sold. So, if your child buys Microsoft and the value of the stock rises by 200 percent, there's no immediate tax to him. The size of his savings has grown because of increases in the price of the stock he owns.
• Capital gains receive special tax treatment. Unlike ordinary income, such as salary, interest, or dividends (which is taxed according to graduated tax rates running from a low of 15 percent to a high of 39.6 percent), capital gains on assets held more than one year have a lower fixed rate of tax. Generally, they're taxed at 20 percent, but people in the lowest tax bracket on their other income pay only a 10 percent capital gains tax. For example, if your 16-year-old's only income for the year is a $3,000 salary, $1,000 in interest and dividends, and $5,000 in capital gains, the portion of his ordinary income that's taxable is subject to a 15 percent tax rate; the capital gains is taxed only at 10 percent. (For kids under 14, the kiddie tax can make them pay the 20 percent adult rate on their capital gains.)

Even without selling growth investments, your child can receive income from them. As explained earlier, growth investments may throw off income in the form of dividends or capital gain distributions by mutual funds.

Changing Allocations

As you've seen, kids have long time horizons for investments and so can wait out the ups and downs of the stock market. They can expect that over the long haul, as has been historically true, stocks will perform better than fixed-income investments. But your child may need money for something that's coming up—buying a car, going to college, starting a business. If the money is targeted for certain special uses, you may have to adjust allocations over time.

• Very young children. Here, allocations may be weighted more heavily toward growth investments. It's still many years away until college or other needs for the money.
• Mid-teens. If money is intended for college, then most experts agree that when your child is about three or four years away from starting, some or all of the money in growth investments should be shifted into fixed income. This will assure that the money needed for tuition will be there even if the stock market dips at the time your child enters college.

Excerpted from The Complete Idiot's Guide to Money-Smart Kids © 1999 by Barbara Weltman. All rights reserved including the right of reproduction in whole or in part in any form. Used by arrangement with Alpha Books, a member of Penguin Group (USA) Inc.

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