When it comes to money, the advice parents usually give their children goes something like this: "Money doesn't grow on trees", or "Close the door when you leave the house - we're not paying to heat the whole neighborhood". Although that parental wisdom has stood the test of time, it takes a bit more effort to teach a child sound financial management principles. (Find out what not to do in 5 Ways To Stunt A Child's Financial Growth.)
The first step in the process is to engage the child's interest. Start with an allowance and have your child dedicate a portion of it to spending and a portion to savings. Be sure to give your child discretion on his/her spending allocation. By giving a child money and the power to make decisions regarding its disposition, you will capture the child's interest and give him/her a sense of responsibility.
Lesson No. 1: Saving
The portion of the child's allowance that is dedicated to savings should be deposited into an interest-bearing savings account. Take your child to the bank when the account is opened and involve him/her in the process. Make sure your child understands the purpose of the account and has a working definition of the term interest.
The child's involvement shouldn't end with that first visit to the bank, however. It's a good idea to set up the account so that statements come in your child's name. When the mail arrives, let your child open the envelope. Review the account balance and help your child understand how and why the balance grows. Give your child a binder or folder and have him/her put each monthly statement in the binder. This teaches your child to be organized and to keep records, and it provides a historical document tracing the growth of the account balance.
Take your child to the bank on the day his/her allowance is paid. Let him/her participate in the process of depositing the money. Remember, the point here isn't to try to turn a $5 deposit into a record-setting investment. The point is to teach your child about money, and lesson one is about saving instead of spending. Your objective is to lay the foundation for a lifetime habit of saving.
Lesson No. 2: Investing
Every child matures at a different rate, but when your child is older, start talking about making money grow more quickly. Most teenagers are able to grasp the basics of stock ownership. Spend some time explaining the concept of risk, highlighting the potential risks and rewards of investing in the stock market. If you can afford it, give your child a few hundred dollars and help him/her research companies that he/she finds interesting, such as toy or gaming companies, skateboard makers, and so on. Walk your child through the process of conducting research using the internet and the resources available at your local library. Most large public libraries in the U.S. subscribe to Value Line, a investment research provider, or offer net access to a variety of finance sites. (For a good introduction to the world of stocks, see our Stock Basics Tutorial.)
When the research is complete, help your child buy shares. Remember, the purpose of this exercise isn't to create a portfolio that will sustain your child through the ages, and it isn't to demonstrate your fine stock-picking skills. The objective is to give your child the opportunity to learn about money and risk and reward by making his/her own choices. If you don't have a lot of disposable money to give your child, or if you are concerned about his/her research and stock selection abilities, limit the investment to one or two companies at $100 each. Online brokerages make this an affordable exercise for almost everyone.
Don't forget that the possibility of losing money is part of the process. Any investor who claims never to have lost money during a lifetime of investing isn't telling the truth. Keep in mind that this should be a learning experience. You are not expected to hand a 13-year-old child the sum of his/her life's savings and suggest that he/she have a go at the markets. The intention is to teach him/her about investing and the consequences of making decisions.
Once again, statements for the brokerage account should be addressed to the child. The statements should go into your child's folder or binder. You can use them to compare the fluctuations in the account balance against the balances from the savings account. Review the returns on the child's portfolio, discuss the results and stick with this process over a period of years.
Look to the Future
As your child matures, he or she can grasp more sophisticated investing concepts, such as the importance of asset allocation and portfolio diversification and the advantages of different types of investment vehicles. You can explain that, as people age or accumulate assets, fixed-income investments may become an appropriate addition to an investor's portfolio. When possible, you can use your personal portfolio as a tool to demonstrate how portfolio construction evolves over time based on an investor's needs. (See A Guide To Portfolio Construction for a step-by-step look at the process.)
Knowledge is power. While some adults may blanch at the prospect of giving their child the freedom to pick stocks, it is important to remember that you won't always be around to do the job on the child's behalf. Bear in mind the old saying about teaching a man to fish and feeding him for a lifetime versus giving him a fish to feed him for a day. Ideally, these early exercises in money management will teach your child valuable financial lessons to last him or her well into adulthood.
While affluent adults will invest substantial sums on behalf of their children, including setting up college savings and personal trusts, giving a child the knowledge required to handle his/her own financial affairs is an equally important parental responsibility. In the long run, teaching children about money may be more valuable than giving them cash and no direction on how to handle it. So, start early and make the experience fun. Good saving and investing habits become second nature over time, and your child will be able to draw on these skills for a lifetime.
To find out how to help your kids budget, see Opening Your Child's First Bank Account and What Are You Teaching Your Kids About Money?