Email
Print Friendly
A A A

Education Resources

Why students need to understand investing basics

investing basicsTeachers know that it is sometimes nearly impossible to get students to focus on next week, let alone next year or the next 30 years. Yet there is a compelling need for young people to understand the fundamentals of investing as early as possible. We can file this entire topic under the "youth is wasted on the young" category, but while they may not realize it, our students are blessed with the single-most powerful investment advantage they will ever have: the luxury of time.

Teaching students to take charge of their future
To get their attention, you might start with some startling statistics:

Chart 1 can help make some of these statistics more meaningful. It shows that the U.S. saving rate, which had ranged around 10 percent of income for many years before 1980, went into a steady decline in the early 1980s, plunging to nearly zero in 2008 before recovering somewhat to about 5 percent currently. (It is important to note that the U.S. definition of "saving rate" represents only the difference between personal income and personal spending, and does not include investments or the value of real estate owned.) The Chinese, with little in the way of a formal government pension plan, currently save about 25 percent of their income.

Connecting abstract concepts to the real world
Now that you've gotten their attention (we hope) with this rather startling data, you can introduce some basic economic concepts. But it's not just about teaching students economic concepts. They also need to understand that they will not be able to count on their retirement being funded by company or government pensions in the future. They will have to provide for a significant amount of their income during retirement, and they will be in charge of how most of their retirement funds are invested.

The first step, then, is to help students understand that learning about saving and investing is about them and their own lives. To begin to understand it, though, they will need to master four basic economic concepts: opportunity cost, the power of compounding, risk/return, and diversification.

Opportunity cost
In introducing (or reintroducing) the concept of opportunity cost, it's helpful to point out that the only way anyone can save money to invest for the future is to give up some spending now. You may want to talk about saving as "paying yourself first" rather than giving up spending now.

The power of compounding
The good news is that younger investors have a fantastic advantage that older investors can only wish for: the amazing power of compounding over substantial periods of time. Chart 2 shows that an investor who started saving just $100 a month ($25 a week) at age 25 and then stopped saving completely at age 35 would amass $200,000 by age 65. This assumes an 8 percent average annual return, which is slightly below the long-term average return for stocks of about 9 percent. On the other hand, an investor who waited until age 35 to start saving but then put in $100 per month until age 65 would only have $150,000!

Huge advantage from starting early (saving $100/month from age 25 to age 35, assumes 8 percent return a year versus starting at age 35).

High school students can do simple compounding exercises using different time and return assumptions. As opposed to becoming a professional athlete, celebrity, or hitting the lottery, saving and investing from an early age presents a very high probability path of accumulating a significant amount of wealth for retirement.

Risk and return
The next step is to introduce the idea of risk and return. Chart 3 presents the concept in schematic form. Lower-risk investments carry lower rates of return. To get higher rates of return, an investor needs to accept higher levels of risk. In this chart, "risk" is represented by standard deviation.

Most high school students do not need to be able to calculate standard deviation, but they do need to understand that it refers to the degree of variation in returns. In the following table, for example, the long-term return from emerging market stocks has been about 10 percent, but that comes with a variation (one standard deviation) of 25 percent. This number tells us that about two-thirds of the time (68 percent, to be exact), returns from this asset class have been between –15 percent and +35 percent. To capture the range on more than 68 percent of the time, we would have to use two standard deviations, and the range of returns would be considerably wider.

This table also allows us to show students what it really means when we say that "lower risk means lower return." The lowest risk among these asset classes, the short-term Treasury bill, has provided only a 3.5 percent return over the long term. (It is even lower when we factor in inflation.)

Diversification
Investors can reduce the overall level of risk in their investment portfolio by diversifying their assets.

As soon as a young person starts bringing in income, he or she is ready to begin the process of saving and diversifying. The study of asset allocation can be complex; students may take multiple courses on it in college and graduate school. High school standards in many states, however, include identifying the major asset classes and being able to rank them by approximate level of risk. Chart 4 provides one way of visualizing asset classes by risk, with the lowest level of the pyramid including lower risk assets and the highest level representing higher risk assets.

Teaching that time itself is an asset The world of retirement planning has changed dramatically, even since the parents of today's students first learned about it. For high school students in today's economy, waiting until they are in their forties to start saving and investing would most likely leave them short of their retirement goals. It will be up to them to understand and take control of their own personal financial situation. The good news is that they have the irreplaceable luxury of time on their side, a luxury they cannot afford to waste.

By Gary Tapp, director of economic education at the Federal Reserve Bank of Atlanta

March 31, 2011