My dad was the first person to teach me about the effects of compound interest. In an effort to highlight the benefits of saving and investing, he gave me a scenario my young mind could comprehend. He asked me to choose to either receive one hundred dollars today or give him a penny and he’d double it every day for a month, after which he’d give me whatever it came out to be. As a young sixth grader who thought even twenty bucks was a lot of money, I chose the immediate cash. Razor scooters were popular at the time and cost just about one hundred dollars. Though I was not actually receiving the money in this hypothetical scenario, I felt that I made a very wise choice.
That was until my dad pulled out the calendar, probably for dramatic effect, to show what happens to that single penny over time. By Day 15, my penny investment would have already surpassed the cash I took. My dad did not go all the way to Day 30 (it would have climbed to over $5.3 million had he) but the lesson was learned. Two dollars tomorrow may be more valuable than one dollar today.
While a 100% daily compounding interest rate is wildly unrealistic, as is teaching my currently one-year old son the benefits of saving, it’s usually never too early to start teaching the next generation a few things about investing. The following are lessons and topics I look forward to sharing with my child many years down the road to give him the building blocks for hopefully a lifetime of financial success.
Stash Your Cash
In a world where immediate gratification is just a pocket away, it can be hard for young people to fully grasp the benefits of saving. And with current interest rates so low, what is truly the point of putting money aside when it isn’t much better off than at the bottom of a sock drawer?
Enter the piggy bank. Very early on, many of us were given a piggy bank to stash the spare change we found in the car or the birthday money we received from our grandparents. Over time, as the piggy grew heavier and had been flipped over onto the floor of the room several times for counting, the money would find a purpose and you were glad you had saved the money along the way. Little did we know we were learning how to save. By putting aside cash we didn’t need in the present and rather tucking it away for a rainy day at the arcade, we were taking an introductory course in financial independence.
Nowadays, the rainy day fund is called “the emergency fund.” Having witnessed two steep stock market declines and recessionary economic environments with hundreds of thousands losing their jobs within a little over a decade, it is as pressing as ever to make sure you’ve been stashing some of your extra cash along the way.
Teaching the next generation the importance of saving cannot be done without also discussing compound interest. While my own father presented a very extreme example, I’d say that it worked as I still remember the scenario twenty years later. Another useful trick to explain compound interest is to highlight the Rule of 72, which is you take 72 and divide by the interest rate (it can also be for rate of return on an investment). The result is the number of years it would then take to double your money. With current savings rate around 0.01% this exercise is not quite as fun, but it’s a quick and clear way to introduce the effects of compound interest.
Investing Is About Focusing Long Term
There is a lot of research pointing to millennials being hesitant to start investing. A 2016 NerdWallet survey found that 63% of millennials invest their retirement savings in a savings account. This followed a 2015 report by Blackrock that found 46% of millennials believed investing was too risky and that the average allocation to cash was 70%. Who can blame the generation that witnessed the 2007-2008 Financial Crisis as well as the steep recession brought on by the coronavirus pandemic? But it is important to teach the next generation that investing for their future is about thinking long term and creating a mindset that views the up and downs of the market as opportunities.
After building up a comfortable reserve of cash in a savings account, it’s important to then start allocating your funds to an investment portfolio that can offer more substantial returns over many years. There are many books, online courses, simulations, and other free resources available to give an introductory overview on how to get started. And we don’t mean the popular trading apps anyone can download on an iPhone. Day trading with zero experience investing in the markets is typically not a great recipe for success. A better alternative for a teen with some earned income (summer job) is to invest in a Roth IRA. Mom and Dad can even offer to match contributions. Investing in an Roth IRA may be boring compared to day trading, but this approach forces thinking further out than just six months to a year and has provided better returns with less volatility in the long run.
Whichever way they decide to learn, the important thing is that they take that first step. To pique interest, bring up the Rule of 72 to show how someone can double their money in approximately 10 years given a 7.2% rate of return which is well within the historical range for the S&P 500. This does not even consider what consistent inflows of additional funds can do to the projected future value of your portfolio, such as the automatic contributions to a workplace retirement plan.
You Will Swing and Miss
A final bit of wisdom that is crucial to impart on the next generation is that they will not hit the ball out of the park 100% of the time. In fact, there will be plenty of swings and misses in life so learning how to properly diversify will keep the at bats coming. Investing, like most things, can be very humbling and is a continuous learning experience. While it may be wise to question the herd when the common phrase is “but it’s different this time!”, rarely, if ever, do investors see the exact same circumstances play out in the exact same fashion. Because there is a bit of estimating involved in any forecast, nothing is certain. It is important to understand and recognize the imperfect nature of investing and learning, over time, how best to allocate within your portfolio.
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IMPORTANT: This information should not be construed as tax or legal advice. Please consult your attorney or tax professional before pursuing any of the strategies described above. Nondeposit investment products are not insured by the FDIC; are not deposits or other obligations of, or guaranteed by, Peapack-Gladstone Bank; and are subject to investment risks, including possible loss of the principal amount invested.