A wise graduation gift: Investing know-how

By Jon Markman

Now that the warm glow of Father's Day has worn off, it's time to come clean on how dads really view their sons.

In my heart of hearts, I know that one day the teenage omnivore who wished me a happy Father's Day from the dugout of a windswept baseball field in eastern Washington last weekend will become more than the sum of his genetics, education, coaching, parenting and quarts of Gatorade. He will be a friend, a partner, a lifelong guide to the unexpected.

But for now, he sure seems like a financial black hole the size of Yankee Stadium. There are plenty of short-term and long-term psychic rewards from all that we invest in our kids, yet let's face it: A 14-year-old is where $20 bills go to die.

In recognition of this impoverishing aspect of fatherhood, I decided to forgo a traditional eighth-grade graduation gift for Joe this month and instead open a brokerage account for him. In around 10 years, he's going to have to be financially independent, so he might as well start to learn now how to leverage the capitalist system to his advantage.

A small sum and a contradiction

As I got to thinking about his account, which will start with $500 from my wife and me, $200 from my mom and $100 from an aunt and uncle, I realized that his predicament is similar to one faced by many readers. You've got $500 to $1,000 to invest. You want to preserve that capital, because it's all you've got, but you want it to grow, too. That's a contradiction, because to get that money to grow, you've got to put it at risk. So what's the best way to get started?

Here's the plan I'm putting together for my son and which I'll pursue for my 12-year-old daughter when she graduates from middle school as well. It's focused on beating the market, because we're competitive and stubborn, but doing so in a prudent way that combines a spark of their tastes, view of the future and risk tolerance. I'll encourage Joe to aim high, at lofty 15% annual pretax returns, but not to feel disappointed if that doesn't happen. The goal is to steadily create an investment account worth $100,000 by the time he turns 30, first using parental gifts and then his own savings.

Keep costs low

My first recommendation is to keep costs as low as possible, and that means he needs to steer away from high-expense mutual funds and keep trading to a minimum. I am suggesting he start with three exchange-traded funds for 80% of his money, and two stocks for the remaining 20%. At $9.95 per trade at Schwab, his positions will cost $49.75.

That puts him 6.2% in the hole right away, which is pretty scary when you're trying to make 20% a year. It also teaches a valuable lesson about how hard it is to make up a deficit -- and why you always want to try to keep losses small. If you want to make 20% on $800, after all, your goal is to end the year with $960. But if you start with a $50 deficit, now you've got to earn 28% to get to $962. That's a lot tougher.

Reams of academic research show that costs are a key reason investors underperform the market. Another reason, though, is that investors tend to hold too much cash when the market is rising because it is human nature to fear a downturn and thus hug a safety blanket. My experience suggests it's hard to time the market's ups and downs well enough to justify holding cash, so my second recommendation is to put all his money to work within a month, in three chunks: the first and largest part right away, and the smaller parcels on any 3% to 5% broad-market declines.

To beat the market over 12 months, you typically need to have your money in sectors and stocks that are beating the market right now. And it would help to develop a view of the future that is at least slightly at odds with the average investor's view. The great hedge fund pioneer Michael Steinhardt calls this contrarian outlook a "variant perception," and you can spend a lifetime in the business developing the ability to do it well. So my third recommendation is that he spends a few minutes a week thinking about what the world is likely to value most in 12 months but is undervaluing now. That's a tall order at 44, much less 14, but it's doable if you turn off your iPod and stop text-messaging for a short while on the bus home from school. There's an exchange-traded fund to match every variant perception, so the next step is to visit the iShares, Powershares or ProShares Web sites and pick a handful. I'll tell him to choose at least two that are handily outperforming the market now and at least one that is just starting to outperform after at least a couple of years of underperformance.

Continued: Tapping into his knowledge

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