This is the third blog in a four-part series, designed to help you engage your adult children in conversations about financial planning. Read all of our entries in the Road to financial independence series:

Part 1: Budgeting  

Part 2: Starting a new job 

Part 4: Helping children on their financial journey 

As a parent, you may have often told your children to  “invest in your education,” “invest in your relationships,” or “invest in your well-being.” While investing in each of these areas requires something different–whether that is focusing on learning, growing networks or simply keeping an active and healthy lifestyle–these actions all share one characteristic: they yield returns over the long run.

When thinking about earnings or savings, it is no different. Investing time and resources into allocating money today can be a key step toward building wealth for the future. Consider sharing with your child the following tips and information to help them understand the benefits and basics of investing as they begin their voyage to wealth.
 

The case for setting out on the voyage

If on January 1^st, 2003, you decided to keep $1 million under your bed, 20 years later, you would have still had that $1 million–assuming no calamity happened to that cash! But because of inflation, which grew roughly at 2.5% over that period, your purchasing power would have been reduced to a mere $610,000. Had you, alternatively, invested that money into the stock markets, you would have made around four times your money.¹ What a difference that makes!     

Figure 1. Illustrative returns on $1M invested 20 years ago by asset class ²

Figure 1 shows only three ways to invest as illustrative examples: cash, treasuries (U.S. government-issued debt), and the stock market. However, there is a myriad of ways to put your capital to work.

Loading the ship

Understanding your options of where to invest can be a great place to start your voyage. These options are the basic building blocks of any portfolio. In investing lingo, they are called asset classes, groupings of investments with similar characteristics and governed by the same laws and regulations.

While stocks and bonds may be some of the most common asset classes, there is a whole world of alternative assets such as private equity, hedge funds and real estate. Each asset class has a different profile of not only risk and reward, but also level of liquidity for the investor.

Some of the most common asset classes are shown in Figure 2.

Figure 2. Examples of asset classes

Furthermore, you can also choose to invest in many of these asset classes actively (i.e., employing a strategy designed to outperform a given benchmark’s performance) or passively (i.e., employing a strategy designed to match a given benchmark’s performance).

How you choose to invest among various asset classes and in what proportions is called asset allocation. There are pros and cons to electing various asset classes and investing styles, but ultimately your choices should align with and reflect your goals and needs.  
 

Following your compass

Before you even embark on the voyage of investing and portfolio construction, it is helpful to understand yourself and what you wish to achieve.

1. Desired rate of return

First, asset class selection should match a target level of wealth you hope to achieve by a certain period of your life. When you are young, you may desire higher investment returns to get to financial independence. Or maybe retirement is on the horizon already, so it is preferable to have steady, income yielding instruments that help pay monthly bills.

2. Risk appetite

Second, knowing your own tolerance for risk is also important. Even though the stock market could return 10% annualized over the long run, in any given year it could also experience significant declines. Bonds return less because their coupons are fixed or capped, but the risk is also much lower.     

3. Liquidity needs

Lastly, it is critical to assess at which periods of your life you need access to your money. Perhaps down the road you need to fund a child’s education or upsize your living arrangements. If you locked up too much capital into very illiquid investments such as private equity or venture capital, you would be stuck – even if they could have yielded higher returns. Instead, to have that flexibility, putting more money into stocks or funds with regular withdrawal allowances would have been more optimal.

Sailing the risk-return spectrum

Of course, there will always be a risk-reward tradeoff with any choice you make. Typically instruments that have the highest expected returns often bear the highest risks. Constructing a balanced portfolio of investments should inevitably reflect these preferences.     

Figure 3. Asset class performance over the long-run vs. in bad times⁴

Sources: Bloomberg, Ken French's website, Citigroup, Barclays Capital, S & P GSCI, MIT-CRE

More importantly, by having a mix of various types of assets, you can diversify your portfolio, a strategy analogous to not putting all of your eggs in one basket. The right type of diversification not only reduces non-market risk, which can arise when a company’s factory gets flooded or when a product launch fails, but it can also enhance overall returns.

Charting a course 

While it may seem daunting to navigate the waters of investing, it is nevertheless imperative to take the plunge. The rewards at the end of the voyage are worth it. And should you arrive at an impasse or have questions, you can always seek professional advice. Reach out to your CIBC Private Wealth relationship manager for more information. 

For more information on helping your children on the road to financial independence, read our first two blogs in this series on budgeting and starting a new job. 

Sofia Hou is a senior investment analyst for CIBC Private Wealth with ten years of industry experience. In this role, she covers general equity research for the firm’s proprietary investment strategies.