How to prepare your teens for investing in their financial future
Learning how to invest early in your life is never a bad thing, but it can be a bit tricky without someone guiding you. I imagine when you were a teenager, there wasn’t a great deal of information on investing. Unless you knew an investor, you might never have thought about it at all until much later.
For today’s teenagers, it’s quite the opposite. They have a wealth of information you probably didn’t have, but at the same time it can be difficult to discern what’s good advice and what isn’t.
The object of today’s post is to help you guide your children, grandchildren, or other young relatives and friends to help them develop their financial literacy with four quick, useful lessons.
Lesson 1 – Risk and Return
British Billionaire John Caudwell probably summed it up best when he said: “In any business opportunity, you’d be looking… at the risk and return. Some business can be very risky with a low return; what you want is the lowest risk with the biggest return.”
The trick here is identifying investments that are both safe and suitably profitable, but how does that work in a practical sense? Well, you’ll find a good illustration of that in the relationship between interest and credit score in the unsecured peer-to-peer lending market.
To give you a little background first, unsecured loans are those where the borrower does not have to put any asset up as collateral, such as their house or car. Instead, they need some sort of reference to show they’re able to repay the full amount borrowed and won’t miss any repayments.
This is where credit score systems like FICO come in. Everyone’s credit score is based on their financial history, taking into consideration past debt, repayments, whether they regularly go into their overdraft, their income, and things like that.
This data results in a number. The higher this number, the better and the more trustworthy they look to lenders – they represent less risk because they’re statistically more likely to pay back the loan on time. As a result, the interest rates they charge borrowers with good credit scores will be lower than those with bad ones.
For example, at the time of writing, to take out $1,000 over 12 months with an excellent credit score (720-850) will come with an interest rate of 13.9%, whereas with a bad credit score (350-629), it’ll be 27.2%.
So how does this relate to investing? Well, in the peer-to-peer lending market, the role of investors is to provide the capital for loans. Investors choose which loans they want to back and that decision is based on how much risk they’re willing to take.
As an investor, you can go for the safer option with a lower return, or you can roll the dice in the hope of a bigger payday – it all depends on your appetite for risk.
In any case – you should always do your homework on the level of risk involved, weigh it up against the possible returns, and then decide whether the investment is for you or not.
Lesson 2 – Diversification
Diversifying is the same as saying, “Don’t put all your eggs in one basket”. Financial markets of the world are greatly affected by what happens socially and politically, and if you’ve got your savings tied up in just one investment type, country, or asset, it can be wiped out overnight.
Let’s take the COVID-19 pandemic as an example. One of the consequences of the pandemic is that people had to stay at home rather than going to work or traveling. This meant that all over the world, people and companies weren’t buying much fuel because they didn’t need to and the demand for it dried up.
When demand for something decreases, the price of both the product itself and the materials required to make it will also decrease. The result of people staying at home meant that oil prices sank spectacularly. If you had all your savings in the WTI Crude index, for example, at the turn of the year they’d have been worth around $60 a share, whereas in April, they were worth around $11.50.
The pandemic hasn’t been bad for all companies though, and for an example of one of the winners, just take look at Amazon shares. Since the beginning of lockdown, the increased demand for products delivered to your door meant that their shares increased well over 30% during this time.
The reason that diversification is important is that when something big happens that has worldwide consequences, we don’t want any or all of our assets on the losing side. When you invest in a range of things that aren’t necessarily connected, like our examples of Amazon and WTI Crude index shares, then a good investment can mitigate a bad one.
We can’t legislate for everything that’ll happen in the world, but we lower risk by diversifying our assets.
Lesson 3 – APR vs APY
The next thing to look at is how interest works and specifically the difference between the terms APR and APY.
APR stands for annual percentage rate and measures how much your money will grow at a flat rate over the course of a year. For example, if you invest $10,000 for a year with a fixed APR of 10%, you’ll make $1,000.
APY, however, stands for annual percentage yield and involves calculating and paying interest more frequently than once a year. The total from the previous calculation is carried over, or compounded, so your interest earnings contribute to faster growth. If we use the $10,000 figure but with 10% APY on a plan that compounds every month, you’ll make $1,047.13.
Now while fifty bucks a year isn’t a life-changing sum of money, it’s not insignificant either and the whole point of investing is to build steadily. The point is to assess your options carefully and plump for a safe investment that will compound interest as highly and frequently as possible.
If you’d like to learn more about APR, APY, and compounding interest, we’ve got a more detailed blog post on the subject you can check out.
Lesson 4 – Inflation
The most important thing to remember when it comes to inflation is that you need to stay ahead of it.
Inflation happens for a variety of reasons, but the result is always the same – the dollar’s value weakens and prices increase. As you can imagine, this is bad news for your income and savings, as now you technically have and earn less than you did.
So how can you mitigate this financial setback? You should find investments that have a better yield than the rate of inflation. While that rate changes, the Fed aims to limit it to 2% per year, and in the last four years it’s been in and around that figure, ranging from 1.9% – 2.3%. So you know what figure you need to beat.
Thankfully, there are plenty of investment opportunities out there that eclipse that number, just make sure you keep lesson one in mind and do your homework on any risk involved. Our new Loan Originator product offers returns of up to 11% APR – that’s 100x better interest that the top US banks’ savings accounts.
These are the core financial concepts every teen should know. This is just the start, though – with your guidance and support, you can help them become a lean, mean, investing machine with a secure financial future ahead of them.
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