How To Invest For Your Children Or Grandchildren

June 8, 2017

How To Invest For Your Children Or Grandchildren

  • Whether investing for children or retirement, the goal is to maximize portfolio value at a specific future date, not now or in the next six months.
  • Be wary of fees as they eat up a huge part of your future wealth. I’ll show how to avoid them.
  • Temporal diversification and buying companies that create value will do wonders over time.

Introduction

Our greatest treasure is, of course, our kids. I’m a proud father for six months now and I must say that every day since my child was born has been the most beautiful day of my life.

In that spirit, I want to provide the best possible environment for my kid to grow up, but also to enable him to do everything he wants when he is older. This has me, and probably many other parents or grandparents, already thinking about college tuition money, start-up capital for a business venture, helping with the down payment for a house, or simply paying for a wedding or a honey-moon. The notion that you can build a substantial nest-egg with small monthly payments is very attractive to me and will also provide a great educational experience to my kid as it will show him how small actions over a long period of time can bring huge results.

Now, if you’ve decided to set aside a small sum every month for your kid, it’s extremely important to invest that money in a proper way. In this article, I’ll discuss the dos and don’ts.

The Goal Is To Maximize Portfolio Value In 20 Years

In order to maximize the value of an investment 10, 15, or 20 years from now, we have to be very careful in the selection of our investments.

The current corporate environment is extremely skewed toward instant gratification through buybacks as they increase demand for stocks, push stock prices higher, and consequently increase management’s compensation. The problem is that such behavior makes you pay a high price for stocks now while long term value is destroyed.

I’ll show you what I mean by comparing Berkshire Hathaway (NYSE: BRK.A, BRK.B) and Apple (NASDAQ: AAPL). Both companies have grown significantly in the last 10 years, but there’s a very important difference between them. BRK’s earnings in the last 10 years have been $98,483 per share and BRK’s book value increased by almost the same amount as it went from $78,003 in 2007 to $178,070 today.

AAPL’s earnings tell a completely different story. Cumulative 10-year earnings have been $53 per share, but AAPL’s book value increased only by $24. Where did the other $29 go? Well in AAPL’s defense, $10 was paid out as dividends so there remains only $19 to wonder about, or 36% of AAPL’s total 10-year earnings.


Figure 1: Comparison of BRK’s and AAPL’s earnings and book values over 10 years. Source: Author’s calculation.

36% of AAPL’s earnings over the last 10 years were lost in stock buyback activities. As AAPL’s book value is $25.5 at the moment while the stock price is around $154, every time the management repurchases a share, it destroys $128.5 dollars of shareholder value and gives that value to the seller of AAPL’s stock.

So, if you invest for your kids, be sure to invest only in companies that are focused on long term shareholder value creation. If AAPL has a bad year and earnings tumble—and this has happened a few times before in AAPL’s 41-year history, so don’t be surprised when it happens,—there will be no book value to protect the stock price and a drop to $25 can’t be excluded. On the other hand, BRK’s earnings will also drop in a recession, but its book value will keep the stock price high and provide sufficient capital to recreate earnings as the economy improves.

The point is that, to achieve satisfying long-term returns—I’m talking a few decades here,—you have to think about how what you buy now maximizes its value over the 20 years. The only way to do that is to look at the strength of the stock’s underlying business.

Book value that is growing in line with earnings minus dividends is an essential factor to look at for long term portfolio value maximization. Keep reading Investiv Daily as I’ll soon write about and provide you a list of companies that don’t do buybacks and invest in the future instead.

Be Wary Of Fees

Apart from corporate management destroying yours and your kid’s future wealth, brokerage and asset management fees also take away a big part of your portfolio.

The first thing to do is to invest for yourself and not pay unnecessary fees. With a bit of common sense and education on how to invest, everybody should be able to beat the market in the long term without paying any kind of fees. A mere 1% fee over 40 years bites off 31% of a portfolio that grows at 9% per year. If you invest a few thousand dollars per year, we’re talking about more than a million going up in flames. Sorry fees, over the long term, this is simply CRAZY!

Given this, a do-it-yourself strategy will save you more than a million over the long term which isn’t at all bad, and certainly shows you why it’s important and profitable to take responsibility for your own investing.

Going further, as you invest small sums every month, it’s extremely important to minimize transaction costs. The minimum fee for buying or selling stocks is around $4.95 which is pretty high if you invest small sums. The best thing to do is to accumulate funds for a few months and invest a larger sum all at once. A strategy that is extremely helpful in doing so is temporal diversification.

(Important note: there is a broker that markets commission free trades, I haven’t yet had the time to closely look at it but from a quick overview, it sounds like a very interesting proposition for the laid-back parent or grandparent investor. The broker is the Robinhood app. This is not a paid ad. However, please do proper due diligence before switching brokers.)

Temporal Diversification

Now, you might think that putting all the money saved up over a year in just one or two stocks isn’t proper diversification and a banker would tell you I’m crazy. But if you put a year’s savings in only one stock, you’ll make sure to buy the best stock out there at that point in time. You will meticulously look for a company that has good earnings, is currently cheap, and has excellent future prospects. It’s highly probable that such a company will appreciate significantly over a year, so the next year you’ll buy something else. Over ten years, you’ll have 10 great companies in your portfolio, all bought at very cheap discount prices, which will make a wonderfully diversified portfolio.

Just think about how retail stocks are cheap at the moment, a few months ago pharmaceuticals were cheap, a year ago it was commodities, a year and a half ago it was emerging markets, etc. The best way to diversify is over the long term. You can read more about the topic here.

Conclusion

By setting aside a symbolic amount per month, one that you won’t even probably feel, you can work wonders for your children and grandchildren. You never know what it is that they’ll want to do with their lives, perhaps an expensive art school or medical school, so it’s best to be prepared in order to provide them with as many possibilities as possible.

However, be careful not to give your children too much. In the sense that they have the possibility to do anything in their life, but not that they have so much that they don’t have to do anything.