How to almost set a child or grandchild up for life

Investment Funds for Kids

Let’s just pretend that a parent or grandparent contributed $200 per month for a child from age 0 to age 18. Tough, but not unachievable.

By the time the child turns 18, the parents or grandparents will have contributed $43,200. Because they invested it rather than merely earning interest, it will likely have grown. At a fictional annual return of 7% per year, the portfolio would be worth just over $84,000 when the child turns 18.

Now for where it gets powerful! Because the great thing about investing early for a child isn’t really the balance at 18 years old. It is the superior use of time.

This is because the nature of compound interest dictates that your annual growth in dollar terms towards the end of a long holding period is far, far bigger than that in the earlier years.

Consider an investment of $10,000 that is held for 40 years. If I falsely assume linear growth of 7% per year, here is how the annual increase in value snowballs throughout the holding period:

Compounding interest on display

Earning an extra $10k on your principal used to take ten years. After forty years of compounding, it only takes one year. In the last five years, the value increases by $40k. The first increase in value of that size took over twenty-four years!

Getting to this level of the compounding relies mostly on time.

This is something you can’t buy back but can make sure your children or grandchildren make the most of, even if they don’t know it. Starting them off early opens up investment time horizons and compounding possibilities that most people simply don’t have access to.

Have your cake and eat it too?

Of course, compounding in this fashion only works if it left unbroken. While that is easy to say as a forty-year-old that just made the tables above, it is harder to feel that way as a teenager that knows they have a significant sum of money with their name on it.

Is there a way for our children to enjoy some of the benefits of their parents or grandparents’ foresight without throwing away all his/her compounding advantage?

I think there is.

Let’s imagine that the child’s parents or grandparents had invested $200 a month for him/her and that he/she ends up with a $84,000 in a portfolio at 18. A portfolio of $84,000 has the potential to deliver a not-too-shabby level of passive income from dividends.

These dividends could be spent to fund things like travel, experiences, or assist with a first car purchase while the principal can remain invested and potentially keep compounding. Albeit with less power than if the dividends were not spent and were reinvested instead.

At the end of the day, it is up to the child in our story and his/her parents or grandparents to choose. But even knowing that these options are open to you at such a young age is a great start.

An important footnote

When investing on behalf of your children or grandchildren, make sure they have their own IRD number otherwise, the adult’s higher tax rate will be used for tax deduction which will significantly reduce returns.