[This was originally intended as an article for SA. The SA editor thought it was well written, perhaps entertaining, but not article material. It was essentially deemed too basic for SA's sophisticated investor community. But since I wrote it, I thought those that discovered it (especially those with children) might enjoy reading it. There will likely be a second blog (provided I see any comments requesting it) because Part 2 was already begun when I received the rejection notice.]
This is the first of a two part piece on how I worked on building Roth IRA's with my children
I have long been a big fan of IRA's, and especially Roth IRA's, because of their tax advantages and the "magic" of compounding returns over long periods of time. My challenge was encouraging my children to open accounts and put as many of their hard-earned dollars into Roth IRA's as early as possible. Although my children - and I should point out that these "children" are currently young adults - would trust my judgment on selecting investments, I struggled with how and where to begin.
My objective was to get them to appreciate the value of investing in the market to achieve long term financial security. Unfortunately, most young adults don't appreciate how much easier it is to put money away now than to try and put it away later on. This is especially true if you are telling them it is for use 40-50 years in the future. I considered several separate approaches and rejected most. For instance, I thought about talking to them about how the Indians had sold the Island of Manhattan to the Dutch for about $24 in 1626. We had been to Manhattan many times and it never failed to make an impression, so here was something they might be able to relate to.
How about if I told them that had the Indians invested the $24 at 7% compounded semi-annually, they would have more than $7.5 trillion? That would be more than enough to buy all of their favorite places in Manhattan - the theater district and the museums and Rockefeller Center and... It paints a very vivid picture of the magic of compound interest combined with time. Unfortunately, my kids can be very clever. How would I respond to the retort, "But Dad, all those Indians have been dead for centuries!" Okay, time for Plan B.
I figured a 10 year plan might work better. After all, each has attended, or will end up attending, college and graduate school for between 7 and 10 years. It's a period of time they can relate to. I told them that for the last 70 years of the 20th century investing in stocks had returned about 10% per year. I then told them a story about 2 investors. Investor A and Investor B were great friends and graduated together, got jobs at the same company and had comparable pay packages. Investor A immediately began funding a Roth IRA with $5000 and continued investing $5000 per year for 10 years. Investor B figured he had a long time to invest for the future and bought a fancier car and rented a bigger apartment. After 10 years, Investor B decided he should begin investing and opened a Roth IRA with $5000. Guess what? Even if Investor A NEVER AGAIN CONTRIBUTES to his Roth IRA after the 10th year, Investor B won't catch up to Investor A, even if Investor B contributes $5000 every year until he retires. Starting out young allows your money to work longer and harder for you.
Now that I had their interest - or perhaps they were feigning interest to get me to stop talking - it was time to discuss where they would like to invest. Immediately the eyes began to glaze over as I began talking about how there were almost limitless choices out there. I knew if I started listing everything like individual stocks, sectors, mutual funds, ETFs, large-cap, mid-cap small-cap, REITS, LLCs, growth, value, dogs of the Dow, dividend champions... well, I would have never been able to catch them as they ran screaming from the room. Maybe I could take them by surprise in the car, telling them we were going out to dinner, and then while I had them captive... That wouldn't work well either. Too many traffic lights would give them an opportunity to escape.
I toyed with idea of asking them to pick some companies that they were familiar with, whose products they purchased or used, places they shopped or frequented. Both daughters had recently purchased Apple laptops while in grad school. This was partly because of some bad experiences with Microsoft Windows PC's, partly to the educational discounts and partly because they were also getting a free iPod and printer. Should I steer them towards buying Apple stock? At more than $300 per share would it put too large a percentage of their assets into just a few shares? My son, on the other hand, thinks Apple products are overpriced, and needs to use software designed for Microsoft Windows. Should he invest in Microsoft? Maybe I should put him in Kellogg because he seems to live on Pop-Tarts. Instead, I decided to go in the direction of higher risk and potentially greater rewards.
Investors have often been told about the importance of taking charge of one's investments. Investors like me often find that our crystal balls can get very cloudy and we soon discover that we aren't quite as smart as we think we are. What follows may be as much a primer on how not to choose investments as it is a lesson on how much luck can play a part in the long term failure and success with investing.
My son started early. He had been able to get an excellent summer job and had $3000 to invest after the Summer of 2007. He opened a Roth IRA when he came home from college for Thanksgiving. In many ways he is the most laid back of our children and least concerned about money. As 2008 began, we still had not put his money to work. I was looking for the type of investment that had worked well in his custodial account, "value stocks" with a combination of covered calls and dividend yield. I thought Citigroup was just such a stock. It was trading at just under $29, the dividend had just been cut to $1.28 (a 4.4% yield) so I thought the new dividend would be safe for a while, and the premium on a $30 covered call expiring one year out was $4. It seemed a pretty good deal with a return of $5.28 on a $29 investment. Or looked at slightly differently, the net outlay was $25, and I was calculating a $5 capital gain when the stock was going to be called at $30 in a year plus that dividend - well that's $6.28 on a $25 investment and a 25% return. Unfortunately Citigroup would cut its dividend in half by October of 2008, then down to a penny and then down to zero and the share price would drop to $6.71 by the end of the year, and it wasn't done declining.
I also hadn't finished with his investments and would make what looked like another colossal blunder. But first, I had to go to work on my daughter's account. I thought it would be a good idea to put her money into Sirius Satellite Radio. It was a low priced stock with some very high value call premiums on the options. Buying the stock and selling the call looked like a great opportunity. It was February of 2008, the stock was $3.13 and the June $3 calls were trading at $0.70. Net cash outlay to buy 400 shares and sell 4 $3 calls was $985 after commissions, just below the $1000 she had available to invest. If they were called, the net sale would be $1,190 and the gain in 4 months would be about 19%. That might catch her attention. It sure did, and for the wrong reasons.
At options expiration on June 20th the stock closed at just under $2. I turned around and was able to sell Jan 2010 $2.50 calls (LEAPS actually) for $0.70. This brought the "net cost" of the transactions down below $1.80 per share (after commissions) and if the stock reached $2.50, there was the chance for a 39% gain in just under 2 years. Sirius continued its downward spiral until a close brush with bankruptcy in early 2009 and its eventual rescue by Liberty.
By April of 2009 SIRI was still trading below $0.40 per share, my daughter was a bit short of cash, and I wasn't ready to tell her to put more into her Roth. I could still hear her saying, "Dad, you lost all my money." It wasn't quite true, but her account was down 60%. Anyway, I decided to wait until her finances had improved. So far it was looking like 0 for 2, and it was about to get just a bit worse.
Back to the second apparent blunder with my son. I still had some of his money to invest after he made additional contributions in April of 2008. I was still a believer in Sirius at that time and the price had fallen to $2.44 per share and it seemed a safe decision to buy the stock and sell $2.50 calls expiring in Jan '09 for $0.50 each. After all, the net cost would be under $2.00 per share and it seemed a gain of more than 25% (selling SIRI at $2.50 would give a $0.50 profit on the net cost of under $2) would be easily achieved. There was still more than $2000 of cash in the account after buying 1500 shares of Sirius and selling the 15 covered calls, but it was time to take a break.
The apparently low cost wasn't low enough to make up for what happened to Sirius, and by the end of 2008 his equities were looking horrible. The 12 month bar chart plotting the value of his account was becoming one steady downward slope. As the year ended the entire economy was a mess and it was about to get much worse. The markets had dropped dramatically and they were about to go even lower in early 2009.
Part 2 of this experience will begin with 2009 and take us to the present.