Investing for your kids

Children have much longer investment horizons than adults, so if you start investing for them when they are young, it can make a big difference in their lives.

By Ken Kam Dec 23, 2009 3:33PM
When my daughter was born I set up what I call a "Bicycle Trust". Its mission is to assist her to become a self-sufficient and a valuable member of society. Just as a bicycle enables you to travel farther and faster than someone on foot, we want this trust to amplify her own efforts so she can go farther and faster than she otherwise would have. But, a bicycle won't take you anywhere unless you pedal. If for some reason, our daughter doesn't want to do the "pedaling" required to develop her talents, we would rather have the money go to help another child (or grandchild) who does.

The power of compounding over long investment horizons is truly amazing. I calculated that if I put aside $2,000 a year, and we got the long-run average market return, by the time my daughter turns 70, those $2,000 annual gifts will have grown to more than $30 million! It's enough to make a big difference in her life.

My daughter is now 6 years old so I can be aggressive with her account. However, this does not mean I want to accept the risk of losing half her money in the next systemic crisis. Even if the market averages 10% a year for many years in the future, her account will be much smaller if she loses half her money next year. The market has suffered losses of this magnitude twice in the last 10 years so believe me when I say it can happen. If it only happens once in the next 10 years, it will be an improvement.

For the past 10 years, the market has seen great booms followed by devastating crashes. If you stayed 100% invested all of the time through the last 10 years, you would have lost money. To make money in the last 10 years, you had to make some tough decisions about when to be in the market and when to be out. Over the next 10 years, I expect to see more booms and at least 1 crash, so making tough decisions about when to be in or out of the market will continue to be the key to making money.

The problem is that these decisions that are essentially judgment calls because you never have enough information when you make the call to be absolutely sure that you've made the right one. I firmly believed that some people are better at making these judgment calls than others and that the people who are most likely to make the right calls in the future are those who have a good track record of doing so in the past. I used Marketocracy's database to select a team of analysts who each have a proven long-term track record that gives me confidence they can make these judgment calls better than almost anyone else.

Right now this team is telling me to be defensive. The market has had a strong rally since the lows in March, but I am hard-pressed to find evidence of a strengthening economy that would justify the advance. The rally accelerated when the government first reported two months ago that the economy grew by 3.5% in the third quarter.  At the time of the report, I noticed that the growth rate was inflated by a big increase in government spending. Now, I ask you, is it a recovery if the only people who can spend money are those who don't have to earn it? I don't think so.

In the last two months, the government's estimate of third quarter growth has been cut twice, first to 2.8% and now to 2.2%. It is now clear that the initial report of strong economic growth that accelerated the market's rally was an illusion. The reality is that when you exclude government spending, the private sector may have actually contracted in the third quarter.

If the current rally does not reflect a strengthening economy, what should we do? I think we should be thankful for this opportunity to sell while the market is close to its 52 week high and even take steps to protect ourselves with a small hedge.

One of the financial crisis' biggest lasting impact has been the collapse of credit for small companies like those in the Russell 2000. This makes the ProShares UltraShort Russell 2000 ETF (TWM) a good choice for a hedge. If there is another crisis, small companies will fall hard, just like last time and this leveraged inverse ETF is designed to rise by 2x the drop in the Russell 2000.

But if, as we all hope, the market continues to rally, a contracting (or slow growing) U.S. economy combined with continued lack of bank financing create strong headwinds for small companies. In this scenario, TWM may lose money and you have to look at the loss as the cost of providing some protection against a sytem-wide crash. It may help to think about this position like fire insurance for your house. Is fire insurance a bad investment if your house doesn't burn down? On the contrary, fire insurance enables you to enjoy an asset you could not afford to lose. That has value. Similarly, adding a little TWM to your portfolio gives you some protection from a systemic crash and enables you to sleep better at night with a portfolio of stocks even though there is a risk of losing nearly 50% in a crash.

In this era of systemic risk, investors have to protect themselves because most mutual funds, index funds, and ETFs are designed to stay 100% invested no matter what happens. We recently published a special report detailing the end-of-year judgment calls we are making for our clients and an explanation of how we make them.  If you would like to receive the full report, What Should Investors Do Now?, click here.  I sincerely hope you find the full report useful as you evaluate your investments at the end of the year.
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