A few weeks ago I released a blog ‘How to teach your kids about: The Stock Market’ (which you can find here). It sparked real interest from readers and their kids wanting to know more about the detailed next steps to investing so I’ve created this Part 2. How do you pick which companies to invest in? To help explain this to kids, I like to pretend every company available on the stock market is a different food ingredient from around the world. Over time some of these ingredients will be deliciously fresh (i.e. a company that performs well) but some will turn rotten (i.e. a company that underperforms or goes bust). The challenge is that unlike seasonal ingredients, there is no real way to predict when companies will be fresh or rotten. Investing is all about picking which ingredients make a nice meal and where best to eat it.
STEP 1 - Cook or Eat out? You could cook meals yourself each day if you had the time to dedicate and the desire to research ingredients. This is what some people do but it can be very hard to absorb all of the information out there and to keep up to date with which ingredients are currently fresh. Admittedly, some people will get lucky and create very tasty meals, but over time ingredients can turn from being fresh to rotten without much warning. Therefore, it may be best to eat out with a chef picking ingredients and designing the menu. In terms of investing this means giving money to an investment company who will pick companies for you (design the menu) and invest it. There are lots of different places to eat out (investment companies) which offer different menus. STEP 2 - Which type of food should be on the menu? Before you pick which place to eat out at (investment company), you need to narrow down which type of ingredients you’ll want their menu to include. For example, you could consider an only British food menu (i.e. only UK companies, investing in the FTSE which is the UK stock market) or, only ingredients with high energy levels (i.e. targeting all global energy companies).
You might instead want to make sure you don’t miss out on any of the freshest ingredients and that all are included on the menu (i.e. investing in a global equity fund). This reduces the risk of the menu getting ruined if some ingredients go rotten or get damaged. For example, if you just wanted a menu with ingredients from the UK but big floods occurred which damaged crops all meal choices would be ruined (i.e. if there was a big fall in the UK stock market).
Consider the healthier options
Increasingly people are becoming more health conscious and opting for healthy food ingredient options. You could therefore consider removing unhealthy ingredients from your chosen menu provider.
In investment terms, this means giving more of your money to companies dedicated to make the world a better place (e.g. companies who use renewable energy sources). This investment approach may affect your financial performance return (either up or down compared to including all companies regardless of their social responsibility) but arguably it’s important we all do our part to help the world.
Jargon financial terms for this approach are ‘Socially Responsible investing (SRI)' or 'Impact Investing'). For more information on this topic please read here.
STEP 3 - Pick where to Eat out?
Now you have chosen to eat out as opposed to cook yourself and narrowed down the ingredients you want to see on any menu, next you need to choose between a fancy restaurant or a café (i.e. pick the type of investment company to invest for you).
The Fancy Restaurant
A fancy restaurant could use all your ingredients but will instead try to pick only those they thi
nk will be most fresh day to day, so their menu changes frequently. This constant menu redesign and the need for specialised chefs takes time and so they charge high prices.
Sometimes they do pick the freshest ingredients and make the tastiest meals (i.e. make you a lot of money by picking companies that perform well versus the stock market average). There are, however, times when the fancy restaurant inadvertently picks rotten ingredients. This results in a disappointing meal and possibly the worst you have ever tasted (i.e. you lose money as they mistakenly pick companies that under perform the stock market average).
In short, at a fancy restaurant you may taste some amazing meals but also some very underwhelming meals. Regardless, the meal still has to be paid for and it is expensive. This is called ‘active management’ - you pay an investment company a high fee to try and individually pick companies that will perform well relative to the stock market average.
The Café
The other option is to go to a Café which has one, fixed, menu and uses all the ingredients you have narrowed down to include. The meals may differ somewhat in quality as the freshness of the ingredients varies day to day (i.e. the entire stock market goes up or down). You may also miss out on some really amazing meals like the ones sometimes produced by the fancy restaurant. At a Café you can, however, avoid really disappointing, rotten dishes and you pay a lot less as the menu stays consistent.
This is called ‘index tracking’ - you pay an investment company to invest in your chosen market(s) without trying to pick individual companies who may win or lose. Fees are much lower than you would pay for active management (the fancy restaurant).
Fancy restaurant or Cafe?
Given the choice, I opt for the café. I get a reasonable meal and don’t pay too much for it. It’s also relatively easy to pick a café as they are all pretty similar versus fancy restaurants whose menus and chefs (active investment managers) often change. I know that whilst the fancy restaurant might have had good recent meal reviews, what they cook in future might be vastly different (super important message here - past investment performance is not a good guide to the future).
Summary
My kids who are both under 8 years old now know that how we choose to invest in the stock market is like eating out at our regular café which has a large menu of set dishes (but now with more healthy items included!).
They understand the way we invest is simple compared to something complex and expensive (i.e. in the world of investing we don’t home cook but, we don’t go to fancy restaurants).
I believe that teaching them this lesson will have given them a big advantage in life as a lot of other kids will grow up believing the stock market is complex and expensive.
If you are a parent and want to invest in the stock market for your kids then:
Consider whether you are going to cook yourself or Eat out (i.e. whether to use an investment company) - best to Eat out
Consider which type of food ingredients you want on the menu (i.e. which market or company types to invest in) - the more ingredients, the better
If eating out, pick where, a fancy restaurant or a café (i.e. ‘active investing’ versus ‘index tracking’) – personally I prefer a good, old café!
If you want to invest in an index-fund then check out our 3 step guide to opening an investment account.
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Will