Categories
Wealth

How to Give Your Child a Massive Financial Head Start

Something that is often forgotten in the personal finance field is that young kids have a massively long time horizon. The finance industry tends to ignore the compounding capability between ages 0 and 20, only to think of people as savers once they start working.

Sadly, this is detrimental to children. Because young children have such a long time horizon, a fairly small amount of savings can go a long way due to the benefits of compounding. Effectively, savings and investments made during childhood can give a child a massive financial head start.

Because young children have such a long time horizon, a fairly small amount of savings can go a long way due to the benefits of compounding.

So why is this cohort ignored?

The personal finance industry – made up of advisors and asset managers – earn fees on dollars that come in the next quarter. The larger those dollars the larger the fees. So it doesn’t pay to provide advice to people with small account sizes. I’m hoping this article can help fill the void.

I’ve previously explored how high school kids can create $1,000,000 in wealth by working summer jobs.

The following idea starts even earlier than high school, is easy to implement, financially feasible and doesn’t depend on a child’s ability to find work. Frankly, anyone can do this and help give their child/grandchild a massive financial head start.

Most newborns have four grandparents. If each grandparent contributes a manageable $25 per month into an investment account earning 7%, the child would have accumulated $51,430 by age 20. Imagine what a 20 year old could (responsibly) do with this money: pay college tuition, make a down payment on a property.

But why would the grandparents fund the account alone? What if the parents also each contributed $25 per month? In this case, the child would have accumulated $77,145 by age 20. Just that additional $50 per month results in a massive increase in value. This alone gives the child a massive financial head start.

Let’s say the child at age 20 pretends this money doesn’t exist.

What if at age 20 the child opted to leave that money invested until retirement without making any additional contributions?

By age 65 the child would have accumulated $1,620,227. Of course, this doesn’t account for a higher cost of living down the road, but no matter how you look at it $1.6 million is a huge sum of money. Especially considering the child never had to invest a penny.

Of course, like most of us, the child would likely contribute to his own investment portfolio. What if – after receiving the portfolio at age 20 – the child continued to contribute $150 per month until age 65? By age 65 the child would have accumulated $2,153,876!

Time is on a newborn child’s side. Unfortunately, that time is typically wasted. An extra 20 years of compounding early in a child’s life can add massive amounts of financial wealth for little upfront investment. So if you or someone you know is about to have a baby or already has a young child, share this with them.

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Categories
Investing Wealth

Compounding and the Self-Funding Portfolio

“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”

Albert Einstein
Aivazovsky Shipwreck, 1856, pencil and gouache on paper

Let’s say you’re 20 years old and have 40 years until retirement. If you’ve been reading this blog you know that you need to start saving and investing early to get time on your side.

You’ve also probably seen growth charts – like the one below – showing how an annual contribution of $10,000 to a portfolio that returns 6% would grow over the years. This illustrates the simple concept that time + return on investment provide exponential growth over the long run.

This is the power of compounding

Compounding describes how an investor gets returns on their initial investment plus returns on the returns on that initial investment. Returns on returns – that’s when your money starts really working for you. That’s when it takes a life of it’s own.

When contributing regularly to a retirement nest egg, there is a point after which your portfolio learns to fly on its own.

In the early days, your portfolio is small. So most of your portfolio’s growth is dependent on your contributions. During this time, investing feels like an uphill battle – it’s more an exercise in saving than generating returns. This is frustrating for many, as the dollar value of annual portfolio returns are small during this period. The vast majority of annual portfolio growth comes from your contributions.

However, over time this eventually changes. At an average annual return of 6%, portfolio returns outpace contributions by about year 13. As you can see in the chart below, once this point is passed, the portfolio becomes self-funding in a way, with the dollar value of annual portfolio returns increasingly outpacing the value of annual contributions. Of course, it is best not to think of the portfolio as self-funding, and you should keep contributing to accelerate future growth.

It isn’t until these later stages that you truly start to see the benefits of compounding.

The chart below shows the same thing as the previous chart, except it shows annual portfolio return and annual contribution as a proportion of portfolio growth. I think this really highlights why people get frustrated in the early years of investing. You can see how in the early years, the only growth is due to your own personal sacrifice. Your friends are spending their paychecks on BMW payments, while you suffer in silence to fund your portfolio with little to show for it.

However, while your friends have a negative net worth 13 years later, you’ve built a portfolio that has really started to take off.