Have you ever thought about helping your children out financially? Maybe you’d like to help out with a house deposit or contribute toward university fees? No matter how much you earn, having the ability to assist your children financially is within reach, by investing in the share market over the long term.
Allow me to illustrate a simple investment strategy that could set your children up for life.
Start early
The greatest tool in the quest to build wealth is the power of compounding. In fact Warren Buffett has said it’s the single most important factor behind his investment success. The key here is time. Over long periods of time, even small gains can compound into large sums and therefore if you’re looking to build a large investment portfolio for your child, it’s best to start early.
Invest in instalments
When building a portfolio it’s a sensible idea to invest in instalments using the process known as ‘dollar cost averaging.’ This reduces the risk of investing a single lump sum at the top of the market and facing heavy losses if the market suddenly tanks.
A simple dollar cost averaging strategy could involve investing a small amount on the birth of your child and then similar amounts each year for the next four. For example, invest £1,000 at birth and then another four instalments of £1,000 each year over the next four years, bringing the total outlay to £5000.
Low-cost funds
If you’re building a portfolio for your child, the investment horizon is likely to be long term – perhaps even 20 to 30 years. And given most studies conclude that shares are the best-performing asset class over the long term, it makes sense to invest in them.
The less you pay in fees over this time the higher your returns. Therefore it could be a good idea to use low-cost exchange traded funds (ETFs) that track indices such as the FTSE 100 or FTSE 250. This would give you exposure to a diversified portfolio of shares at minimum cost. Alternatively you could purchase a low-cost mutual fund.
Once the portfolio is large enough, direct investment in equities could be a good option but in the short term this wouldn’t be advisable as brokerage fees would eat into portfolio returns.
Aim for 10% annual growth
No performance is guaranteed in the share market, but over the long term, it’s not unreasonable to expect returns of around 10% per annum if dividends are reinvested. There’s no need to take excessive risks as slow and steady wins the game. The chart below illustrates the £5,000 investment growing at 10% per year.
While growth is slow in the short term, over the long term the gains become exponential as the compounding really kicks in. Indeed, by the time the child turns 30, the initial £5,000 has grown to over £72,000. That would certainly make a great 30th birthday present.
Of course, taking into account inflation (assume at least 2% a year), the investment might be worth closer to £42,000 in today’s money, but that’s still a significant sum that could really set your child on the path to financial freedom.
Minimise taxes
Lastly, tax. The less tax you pay, the greater the potential growth of your portfolio. For UK investors, a junior ISA could be a good idea as income and capital gains are tax-free.
