As of this year, only eight states in the United States have state-wide requirements for teaching financial literacy in high school. While that statistic may come as a surprise, the reality for most children is that much of their financial literacy will come from life experiences and lessons from their parents, families, and friends. Realizing this, we thought it would be helpful to provide a jump-start to financial literacy with some commonsense concepts and tactics to share with young people to help them establish a life-long and healthy relationship with money.
Starting with the Mindset: Basic Building Blocks
The process of generating wealth is very personal, isn’t clearly discernable, and often has less to do with earnings or the rate of return on an investment portfolio than it does with experiences and healthy financial habits. In short, it’s all about having a positive relationship with money. This relationship can span a wide spectrum, from healthy to unhealthy, as money can mean many different things to different people. Often, the differences in money-meaning can drive the wide disparity in a person’s ability to generate, grow, and retain wealth over time.
Many children have a limited understanding of money. Children can hear about it and witness goods or services being purchased (usually with a swipe or tap of a credit card), but most children have very little exposure to or ability to grasp the concept of establishing a budget and living within or below their means. Accordingly, it’s important to establish the concept of money as a finite, scarce resource and provide young people the opportunity to experiment with money in low-stakes situations.
A good place to start is one of the most important concepts for a young adult to understand: the basic relationship of supply and demand. While the concept of supply and demand is taught in economics class, children are rarely taught how to practice this concept and rarely “feel it” in their own lives.
A simple exercise used to teach the concept of supply and demand is to give a child cash while shopping at a store or concession stand. Provide basic rules: they can purchase what they want using the cash provided and any unspent money can be retained by them to be used for future spending. When placed in this situation, a child’s mindset immediately shifts, and they begin to think through the tradeoff we experience as adults: “to spend or to save.” Concepts like opportunity cost and marginal utility will become a reality, through basic human instinct, without the child knowing the actual terms. In short, the child will begin prioritizing whatever is most important in the context of what is already owned.
If the child has not prioritized the saving over spending, you can further encourage the saving mindset by offering to match any amount remaining, up to a certain dollar amount, at the end of a week or a month. This additional incentive will help develop the child’s propensity to save rather than spend. Ultimately, the child begins to learn the critical mindset of delaying gratification—a skill that is highly correlated with having a strong financial future.
Building Up from the Foundation: Establishing Financial Independence
Once the child can legally work and earn income, financial literacy becomes much more realistic and more impactful. It is crucial that the child begins to learn how to properly manage finances and evaluate the endless spending opportunities at their disposal. One simple way to do this is by being mindful of your own financial processes and sharing those strategies with the child. A simple starting point is introducing the concept of a budget and tracking spending – even if just in a notebook on their desk. Most children have never seen a budget before starting a job. Teaching the child about spending and budgeting and the importance of planning for certain expenses can facilitate an appreciation for the income earned through work.
The process of budgeting also helps children discern the critical difference between “wants” and “needs,” as certain expenses will be unavoidable while others should be considered luxuries. To help develop healthy spending habits as children become teenagers and young adults, assign a certain expense like car insurance or gasoline as a “must have” to the child.
Once the child is comfortable with a budget, the next step is to teach the various methods for saving. In explaining the different parts of your budget, strongly emphasize the monthly savings component of a budget as the most important part of any good budget. Be sure to explain that there are different timeframes for savings that a person must prioritize: saving for short-term needs and saving for long-term needs. The former requires projecting out expenses that could be incurred in the next 6 – 12 months, while leaving a buffer, or an emergency fund, for unexpected expenses. An emergency fund is always critical to any person’s financial well-being and could even be segmented into a separate account to help in segregating funds.
When discussing long-term savings, the concept of investing in securities can be introduced and explained. To start, it must be emphasized that long-term savings are for expenses far off into the future–even retirement! It must be clearly communicated that the goal is to set these funds aside in a diversified pool of investments and allow for compounding to take place. One way to help solidify this concept is to demonstrate the difference between saving early versus saving more but starting later. The power of compounding can easily be shown in a simple spreadsheet. This builds on the child’s understanding of delayed gratification and ultimately increases the child’s odds of being financially savvy. We are happy to help facilitate these conversations as one of our team members can meet with a young adult to discuss savings and investments in more detail.
To help start on this journey, provide incentives that will motivate the child or young adult to prioritize saving for the future. For example, open a Roth IRA for the child or young adult and automate contributions for a set amount of earnings. Then, offer to match that amount up to a certain point outside the Roth to promote good habits and incentivize the child to save for the future.
As wealth advisors, we meet with families every day who have spent their lives raising children and building careers while saving for the future. Other than those who have inherited wealth, every family we meet with has one common trait: they delay gratification and spend less than they earn. Instilling this value into children and young adults is one of the most valuable lessons we can pass on to the next generation. As with many habits, it’s so much easier to start early rather than suffer through the painful experience of learning this lesson late in life, before the magic of compounding can reap its benefits.