When your child is saving her pennies in a jar, it's probably a good idea to keep everything in one place. This way, she'll see how her savings grow by looking at how high the coins rise in the jar. As your child's savings grow into the thousands of dollars, however, keeping things in one place—especially a jar—isn't the best idea. At this point, your child needs to diversify her investments.
Diversification means that your child isn't putting all his eggs in one basket. He's spreading his risk of loss by using different investments because some may do well and others may not do so well.
Asset allocation is a process of deciding how much of one's money to put into stocks, bonds, and savings accounts. The allocation is just a proportion selected for this purpose.
Diversification means putting money into different investments. Maybe your child wants to own stock in Disney, McDonalds, and Apple Computer. Even if Disney goes down in value, this may be offset by increases in McDonalds and Apple. Overall, she's still in good shape financially. In effect, it's hoped that by spreading money around, your child won't suffer too great a loss if one or two investments do poorly.
You and your child must know two key things about diversification: how to allocate assets once her savings account reaches a critical mass, and at what point to change this allocation.
If your child has only a few dollars, he's probably going to put it all in one place, such as a bank account. But as his savings grow, he should be thinking about allocating his assets.
As you've seen, diversification is the idea of going into a variety of investments. Putting that idea into action requires some decisions on what's called asset allocation. There are no magic formulas to use in allocating assets for your child, but experts suggest many different formulas for asset allocation. Here are a couple to consider just to give you an idea of how the allocation process works:
- 80 percent rule. Multiply your child's age by 80 percent to find the percentage of his investments that should be in bonds and other fixed-income investments. Subtract this from 100 to find the percentage that should be in stocks and stock mutual funds. For example, using this rule, your 15-year-old should have 12 percent of his total investments in fixed-income (15 — 80 percent) and 88 percent in growth stocks and stock mutual funds.
- 110 minus your child's age. Here, just subtract his age from 110 to find the part that should be in stocks; the balance goes into fixed-income investments. So, your 15-year-old should have 95 percent of his investments in stocks (110 - 15) and only 5 percent in fixed income. Of course, this formula means that any child 10 or under should be entirely invested for growth, which may not be the best course of action.
Interest is a fixed rate of return on your money. It's expressed as a percentage. If your child puts in $100 and earns 5 percent interest for the year, she'll have $105 at the end of that year; the $5 is interest.
The problem with formulas is that they fail to take into account your child's personal situation. If he has only a few thousand dollars or less to invest, then these formulas don't make much sense; they're intended for more sizable holdings. Also, if there's only a little money involved, your child is in less of a position to risk any losses.
Formulas also don't take into account other factors:
- How necessary the money is to him. If you can afford to pay for his college, then he's in a different investment seat than someone who's investing to get his tuition together.
- How much risk he can stand. Some people are more inclined to gamble with their money and don't lose any sleep over the ups and downs of the stock market. Others like to play it safe And are only happy knowing that their money is FDIC-insured. It's important to know what kind of risk-taker your child is so that he'll make the investment decisions he's more comfortable with. Of course, you'll want to encourage some risk taking, but how far you push things depends on your child's personality.