7 Steps to Teach Kids How to Invest

When it comes to investing, time is your greatest ally. The more time you give your investments to grow, the larger your nest egg is likely to become.

The trouble is that most people aren't taught the concept of investing until their first 401(k). And by that point, you've already lost a decade or more of time.

Just imagine how much wealthier you'd be if you'd only started investing when you got your first after-school job as a teen instead of waiting for adulthood.

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In a recent survey from financial services firm D.A. Davidson, one-third of respondents said children should start learning about financial literacy at age 10 or younger. And yet less than half of states in the U.S. require high school students to take a personal finance class.

Kids learn to add, subtract, multiply and divide, but where are the classes on the importance of saving and investing?

Traditional education systems typically don't teach investing to kids: why they should buy stocks young and how to create a diversified portfolio to carry them through to retirement. So it falls to parents to set their children up for financial success. Luckily, financial literacy is easy to impart from home.

To that end, here are seven steps you can take to teach kids how to invest.

Include Kids in Financial Conversations

If you want your kid to be comfortable investing her money, she needs to be comfortable with the concept of money in the first place.

"Don't avoid talking about money just because your kids are young," says Aditi Javeri Gokhale, chief commercial officer and president of Investment Products and Services at Northwestern Mutual. "Even casual dinner table conversations can be extremely important to help kids understand major topics like what it takes to earn money, to have a budget, to pay bills and to be able to make choices about the things you purchase."

Zuzana K. Brochu, vice president of Financial Planning Strategy at People's United Advisors, suggests parents start teaching investing for kids by explaining how cash flow works. For instance, you get a paycheck and some of that money goes to taxes and some to savings, then you pay your bills and buy the goods you need for daily living like groceries. If there's money left over, you might save more, donate to charity or splurge on a fun item.

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"You don't have to share actual numbers, but make sure you share financial concepts, and especially your values around money," Brochu says. "If you have negative patterns around money, this is a good opportunity for you to heal those not only for your own benefit, but also for your child's."

Teach Kids Investing Is Not a Get-Rich-Quick Scheme

Children also need to understand the purpose of investing – and it's not to get rich quick.

"It's important for kids to understand that money is a tool to help them achieve their goals and dreams, which is a very different mindset than picking hot stocks hoping to get rich quickly," Gokhale says.

She tells parents to start teaching kids about investing by pointing out the importance of saving steadily over time so that you have money when you need it.

"When it comes to investing, talk about it as a long-term prospect rather than a way to make quick cash from the market," she says. "Above all, make sure that kids see that it's important to have a plan for your money that connects to what they want in life – not just a way to live a rich lifestyle like they see in movies, on TV and in many other places."

Help Kids Start Investing With a Financial Goal

To help kids see the importance of having a financial plan, have them set goals for their investments. Just as a financial advisor guides her clients through defining quantifiable financial goals based on what's important to them, parents can help their children define and quantify their own financial goals.

Talk to your kids about what they'd like to save for in the future, whether a new toy or trip to Legoland, says Tammy McKennon, a financial advisor with Edward Jones. Let them choose what is exciting and important to them, then encourage them to save so you can work toward that goal together.

This is also a great way to teach your child about delayed gratification, an important lesson for any investor to understand.

Karen Baer, a senior wealth advisor at The Colony Group, says parents can help children develop responsible financial habits by establishing a system for spending, saving and giving. "This could be as simple as three envelopes with the category written on each envelope," she says. "When your child receives money, help them decide how much should go into each envelope."

As the savings envelope grows, you can segue into how opening a savings account or investing that money would help it grow faster.

Explain the Power of Compounding With Illustrative Examples

The power of compounding is at the heart of how investors are able to have their money make money, but this is a hard concept to explain to small children.

Amy Szostak, director of Family Education and Governance at Northern Trust Wealth Management, suggests using illustrative examples, such as the doubling penny exercise when teaching kids how to invest.

"Ask your child if they think a penny is a lot of money," she says. What if that penny doubled every day for a month? "They might be surprised to know that a penny can grow into over $10 million when doubled every day for 31 days," she says.

You could then expand on this lesson with an actual bank account. "After your child's savings envelope has received several deposits, open an interest-bearing savings account," Baer says. Each month, you can review the statements to show how your child's interest is earning interest.

Then link this to investing for kids by explaining that money in the bank is earning interest because you're lending it to the bank. There's almost no risk since the money is insured by the Federal Deposit Insurance Corp. (FDIC), but also very little return. Your child could grow her money faster through investing in the stock market, but this comes with additional risk.

You can use your child's timeline for her financial goal to help determine which investments would be the best match. If she's saving for a new bike she wants in the next year, maybe a certificate of deposit (CD) or bond fund would be best. But if she expands her goal to something five or 10 years in the future, she can consider stock funds for more aggressive growth.

Pique Their Interest With Companies They Know

The "buy what you know" maxim has been bandied about in investing circles for decades. The idea is to put money in companies you understand, and its key when teaching kids how to invest.

"This is important for everyone when it comes to investing," says Jeff Mills, chief investment officer at Bryn Mawr Trust Wealth Management. "But in terms of teaching kids, if they understand what the business does, if they use the product, they can better understand why a stock price might go up or down."

Kids today have two things going for them as future investors, Szostak says: They're aware of product branding and they are skilled online researchers. "Ask your child what company they are curious about and invite them to spend 30 minutes researching its stock price with you," she says.

Compare its price today to what it was worth one year ago or 10 years ago. Has it been volatile? How would your child feel owning the stock if the price fell?

"To take the lesson one step further, look up the dividend history and explain that for every share of stock they own, they receive the declared dividend amount," Baer says. "Depending on your child's age, you could even go deeper and discuss reinvesting the dividends to continue saving and growing the asset."

Investing in what you know can also help a child become a long-term investor: "If you know the company, and understand what drives its business, you are more likely to stick out periods of volatility," Mills says.

Experience Investing First-Hand With Virtual Stock Markets

It's important not to gloss over the risks inherent with investing. Stocks don't just go up.

Virtual stock markets can be a fun way to give your kid a more hands-on experience of investing without the real risk of losing money, says Bill Engel, a certified financial planner and senior vice president at Fort Pitt Capital Group. He points parents to popular simulators like the Investopedia Stock Simulator, Wall Street Survivor and HowTheMarketWorks.

These simulators can also help you teach your kids important lessons about what makes a good investment. "Just because you like a product or it is popular doesn't make it a good stock," Engel says. Likewise, "time in the market is more important than timing the market."

While there is the risk that virtual trading can "gamify" investing, Engel says by emphasizing these teaching moments, kids will be less likely to get attracted to the "game" of the market when they're older.

Open a Real Investing Account

Once you and your child are ready, you can open an actual brokerage account for your child. If she has earned income, you could have her open a Roth IRA. Explain that it's for retirement and why it's important to start early by showing the time value of money, Brochu says.

Show her how much $100 put in her IRA now can grow and how much it will be in retirement, she says. For instance, $100 invested at age 18 can grow to over $3,000 by her retirement age at a 7% rate of return. What's more: If she puts $100 in every month from now until retirement, she'll have over $500,000 at a 7% rate of return.

You can teach investing for kids by showing them how the investments they choose can impact that long-term rate of return. For instance, the average long-term return for stocks is around 7% to 8% after inflation compared to closer to 5% for bonds. But stocks also come with more risk and volatility.

Since your child hopefully has several decades before she'll need the money, she can invest her retirement savings in equities and enjoy the tax-free growth a Roth IRA provides if she's prepared to wait out any downturns.