Among them, the appreciation of compound interest
I have taught over 1,200 students in my career as a professor. On Aug. 12, I met my most important student: my beautiful baby daughter.
Along with the other fears and concerns that fill the heads of most new parents, I have also been thinking about what lessons I want my daughter to learn about money, based on my experience as an educator and an investment adviser. Here are four that I think are most important.
1. Distinguish between wants and needs. I have met many prospective clients who derailed their retirement plans by confusing luxuries and necessities. People develop the bad habit of saying “I need” instead of the appropriate phrase, “I want,” at a very young age.
The first financial lesson that I plan to teach my daughter is to remind her that she wants a new toy when she tells me that she needs it — and why she needs it.
2. Don’t confuse material possessions with wealth. People often assume that someone with an expensive car or a large house is rich, while the person with a 10-year-old car and a modest home is not. The truth is there are a myriad of wealth-destroying methods, such as not saving for retirement and accumulating high-interest debt, which can be used to acquire expensive cars and appear rich. Acquiring material possessions will not make someone wealthy, but accumulating a large retirement account and paying down debt will.
I will remind my daughter that building wealth comes from spending less than you make and saving the difference, not from purchasing rapidly depreciating assets.
3. Learn and appreciate compound interest. This lesson changed my life when I learned about it in high school. I first fell in love with the idea of compound interest at the age of 15 when my dad taught me the rule of 72, which posits that taking 72 divided by an investment’s rate of return will provide an estimate of how long it will take that investment to double in value. Shortly after, a family friend showed me the exact formula to compute the future value of a lump-sum investment, which further fueled my fascination.
I will likely save this lesson for when my daughter is in high school and has the math skills to appreciate the enormity of this lesson.
I am a firm believer that many financial mistakes that people make, such as under-saving and over-borrowing, stem from a lack of appreciation of compound of interest. I believe that if people knew the massive gains they could earn by making compound interest their friend (by saving) and the destruction compound interest can wreak when it becomes your enemy (by borrowing), very few people would be underprepared for retirement.
I hope that learning the power of compound interest will inspire my daughter to save more and spend less.