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Investing for Children

Dollar Stretcher (featured column)
by Gary Foreman

Q: We have 4 grandchildren that we have been purchasing stock for at Christmas for the last 10 years. The stocks are valued from $500 to $3,000. The brokerage house fees were running too high even though we had them under our account. We have just liquidated the accounts and our goal is to look for the best place to invest this money and continuing our yearly $150 contribution for each. - Rich

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A: Rich is right. Investment expenses matter. The Securities and Exchange Commission calculates that a 1% difference in expenses on a $10,000 investment earning 10% annually would mean a difference of $11,133 in 20 years. Rich isn't investing that much, but clearly the difference is dramatic.

And Rich is also right that beginning a savings program for children is a great idea. For instance, a public college that costs $12,841 per year today would cost $36,652 in 18 years if costs rise 6% per year.

There are two things for Rich to consider. First, how will he invest. And, second, how will the investment be legally owned.

Owning individual stocks is very hard unless you're going to be investing more than $150 at a time. Even a minimal $8 commission reduces your $150 investment by more than 5%. So it takes 6 months or so to earn enough to make up for the commission paid.

Generally, mutual funds offer more flexibility for the small investor. The average expense for a mutual fund that invests in domestic stocks is 1.4% per year. That's a whole lot better than the cost of buying individual stocks.

Owning a mutual fund allows you to reinvest dividends. Something that's almost impossible with an individual stock unless a DRIP (dividend reinvestment plan) is available. If a DRIP is available for your stocks in this situation it would be wise to use it.

Rich will want to consider something called an 'index' fund. Those are funds where management does not try to pick stocks that will beat the market. The fund is managed so that it reflects the make up of an index. For instance an S&P 500 fund would have shares in the same proportion that they were in the S&P 500 index. Shares would be bought and sold to maintain that proportion.

There are two main attractions to index funds. One is that their expenses can be lower. For instance, the Vanguard S&P 500 fund has an expense ratio of about 0.18%. But check the expenses on any fund. Some index funds have ratios as high as 1.5%.

The index funds also generally perform better than the average managed mutual fund. As it turns out, most managers don't earn more than they charge the fund. And that means that the average fund does not perform as well as the market.

If you are going to consider a managed fund, look for one that has a good 10 year track record. A great one or five year track record could have been caused by some unique factors that had nothing to do with the fund's managers. And, that could actually work against the fund once you've bought it.

How should the investment be owned? Ideally, Rich would set up a UGMA (uniform gifts to minors account) for each child. He (or any legal adult) could act as custodian until the child became an adult.

Because legally the child owns the money, Rich would not be liable for any taxes on dividends or capital gains. The one disadvantage is that the child can use the money however they choose when they reach the age of adulthood.

Using a UGMA account has another advantage. As they become old enough to understand, you can review the quarterly statements with them. It's a perfect opportunity to teach them the basic facts about money.

There's another, non-financial benefit of talking to your kids about their investment account. Often children strive to achieve our expectations for them. Knowing that you're saving for their college could encourage them to strive for the grades that they'll need.

Rich might also encourage his grandchildren to add to the fund themselves. Kids often receive cash gifts. If they take just a small portion of each gift and add it to their investment account they'll take a keener interest in the account. And, they'll learn how to be investors.

Finally, one of the most valuable gifts that you can give a child is an understanding of how compound interest works. There's a huge gulf between people who are paying interest on credit cards and those who are collecting interest on investment accounts. Getting on the right side of that gulf is important.

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