In this article we are going to take a deeper dive into the third pillar of financial literacy: investing. We will examine the most common investments, understanding risk tolerance and most importantly define what investing is and what it is not. Educating the next generation is indeed the key to bridging the current gap in financial literacy.
According to Webster’s dictionary, investing is the commitment of money in order to earn a financial return. Over time those investments are intended to provide us with financial security, flexibility and the ability to achieve our goals, as well as, help others. One may invest in stocks, bonds, real estate, a business, a person, an idea or dozens of other instruments. For the purpose of this of this article we will be focusing on 3 types of assets; cash, stocks and bonds in the context of investing.
- Cash– giving a bank money for a stated return or in some case no return. Your child is a saver.
- Stock– fractional ownership in a company. Your child is a business owner.
- Bonds– lending of money to entities for a return. Your child is bank.
Cash, while not considered a smart investment in the current environment, is important to provide a safety net in the event of unexpected circumstances. Consider it analogous to an airbag in your automobile. Having a cash reserve of 3-6 months of expenses should be a priority to protect you in the event of job loss, health problems or other unanticipated expenses. Having that cushion gives peace of mind. It also protects you from having to sell investment assets in a down market cycle. In the current environment, your cash is almost guaranteed to lose value over time relative to inflation, but it is a necessary evil in order to give your investments the benefit of time. Cash can also be an alternative during times of elevated risk.
When purchasing a stock or stock fund, one is purchasing fractional ownership in a company or companies. If you invest wisely you can earn a substantial return over time. The fluctuation in price and return of an individual stock can be gut wrenching to most of us; thus the importance of diversifying your investments by holding stock in multiple companies. A stock may be classified as a growth or value stock. Growth stocks generally do not pay out profits as a dividend to shareholders but rather reinvest those profits into the business for further growth. Growth companies can be volatile but have the potential to provide outsized returns through an increase in value of the underlying stock. Value companies on the other hand typically pay out a dividend. Your investment return over time is made up of both appreciation in share price and the dividend payments.
Stocks can also be further segmented by the size of the company as measured by market capitalization. The four most recognized groupings are:
- Small Cap 300 Million to $2 Billion
- Mid-Cap 2 Billion to 10 Billion
- Large-Cap 10 Billion to 200 Billion
- Mega-Cap 200 Billion and greater
There are also Micro-cap companies with capitalization of 50 Million to 300 Million, as well as, Nano-Cap companies with capitalization under 50 Million. Finally, stocks can be further segmented by their geographic region – US domestic, international developed, emerging or frontier markets. The performance of any particular part of the stock market will differ from year to year based on current economic environments and conditions and beginning valuations.
In purchasing a bond or bond fund, one is lending money to an issuer which may be a government, municipality or corporation in return for a promise to pay a specified rate of interest during the term of the bond and return of your investment at the time of maturity. While there are many sub classifications within each category of bond, the important message to the novice investor is:
- Bonds provide a predictable income stream.
- Bonds held to maturity get a full return of the initial investment or principal.
- Bonds may offset exposure to more volatile stock holdings.
- Bonds are subject to the credit risk of the issuer and, therefore, the bonds of a financially strong company are safer than those of a less stable company.
With an understanding of the basic differences between stocks, bonds and cash, every investor should now try to define their willingness and ability to take risk (i.e., risk tolerance) and the time they have to invest (i.e., time horizon). While risk tolerance is more an art than a science, there are many methods to assist in making this determination. Time horizon tends to be more concrete with the examples of the next 20 years, until I retire or until age 95. Both should be reviewed every year and always when there is a significant change in circumstances. The following chart illustrates the long term fluctuation in returns from 1950-2020 for stocks and bonds and a portfolio divided evenly between the two.
You will see that the variance between the best and worst returns becomes progressively smaller as we move from rolling 1-year, 5-year, 10-year and 20-year periods. While history never repeats, it usually does rhyme. Preparing a novice investor for these fluctuations is critical to help them put these draw downs over shorter periods of time in perspective.
Today we live in an environment of constant news, Robinhood, commission free trading and a vast array of mainstream media platforms to disseminate information. There are more self-proclaimed “investing” gurus on the likes of You Tube, Tik Tok, and Reddit than investible stocks in the universe. Trying to consume all of this information has the ability to drive one absolutely crazy. Now, more than ever it’s extremely important to talk with the next generation about the importance of investing, what investing is and more importantly what is it not.
- Committing money in order to earn a return
- Long-term in nature
- Not without risk
- A means of achieving your long term goals
When my kids turned 18, I gifted each of them a small “investment” account for their birthday. While they haven’t learned what “investing” is, they have definitely learned what it is not. This is extremely important as the experience is invaluable, engaging, and to my pleasant surprise very entertaining. I hate to admit it, but I sometimes bask in their mistakes as I know the lessons they learn will pay off in the years to come.
Investing is not:
- Short-term in nature.
I would encourage the next generation to learn about stocks and bonds through guided personal experience. Whether they have their own account or follow companies that interest them, it can spark an interest and desire for further knowledge and learning. Experience is indeed one of the best teachers. Through educating the next generation, we help bridge the gap in financial literacy that currently exists.
“An investment in education always pays the highest return”- Benjamin Franklin
The content contained in this article represents the opinions and viewpoints of Cardan Capital Partners only. It is meant for educational purposes and not meant for consumer trading decisions. All expressions of opinion are as of its publishing date and are subject to change. There is no assurance that any of the trends mentioned will continue in the future. Market performance cannot be predicted, so nothing in our commentaries is ever meant to provide any kind of guarantee of future results.