Q: Our grandson is about to graduate from college. Instead of handing him a gift, we thought we'd open an account and invest $5,000 for him. Our question is: Should we choose only an S&P 500 index fund, or put 80 percent into the S&P 500 and 20 percent into the EFA foreign index? Or should we wait for the stock market to calm down?
-- E. H., Phoenix
A: What a fabulous gift for a graduate -- especially if you talk with him about the investments you have chosen and explain how he can painlessly make the sum much bigger if he adds a little of his own money regularly.
If, for example, you invest $5,000 in the stock market index funds you mentioned, and he adds just $25 a week throughout his working life, he could have about $1 million by the time he retires. Without his contributions, your $5,000 would probably grow to about $285,000 if the stock market behaves over the next 45 years the way it has since 1926 -- climbing about 9.4 percent a year on average.
Notice I said "average." Anyone with money in the stock market in 2008 and early 2009 learned painfully that the "average" doesn't mean positive results every year. Investors lost 57 percent during the horrible bear market, then gained 80 percent between March 2009 and this April, and then lost about 12 percent again. The historical average of 9.4 percent a year is a blend of the stock market's cruel and benevolent periods.
If he'll access the money soon: Because no one can predict when the stock market will be kind or cruel, the stock market -- or the Standard & Poor's 500 index fund you are considering for your grandson -- is not a good choice for someone who will need to use the money soon. So if you told me that you wanted your grandson to use the $5,000 gift for a down payment on a house in about five years, I would tell you to skip the stock index funds you mentioned or any stock investments. In the short-term you cannot count on the stock market. So bank CDs or U.S. Treasury bonds would be safer.
If he'll access the money later: But if the idea is to give your grandson a start on saving for his distant future, then your choice is ideal. A Standard & Poor's 500 index fund mimics the stock market and will give your grandson a chance to own a tiny piece of 500 of the nation's largest companies -- everything from Apple to Exxon. It's a stock fund that can be purchased when young and held for a lifetime. You could put some money also in an index fund that invests in the MSCI-EAFE index. That would give your grandson exposure to many of the world's largest companies -- from Nestle and Bayer to Canon and Honda.
With a number of European companies, this fund will likely decline while investors worry about the ongoing European financial crisis. And in a global world, the S&P 500 index fund won't be immune.
To avoid putting money into either fund and watching it decline in this turmoil, you could open an account at either a mutual fund company or a brokerage firm like Fidelity that lets you buy shares in exchange traded funds without paying a commission. Then, you could put a little money into the iShares S&P 500 exchange traded fund (IVV) and the MSCI EAFE fund (EFA) a little at a time over the next year. This is called dollar-cost-averaging, and it would allow you to buy some shares in the funds cheaper if the stock market keeps falling for a while. But if you'd like to deposit your full $5,000 at once and be done with it, studies show lump sum deposits do as well as dollar-cost-averaging over time.
If he'll access it in retirement only: Most importantly, if you are thinking of the $5,000 as a start toward retirement saving, open a Roth IRA for your grandson and invest in the index funds within the Roth account. Then your grandson will never have to pay taxes on the money as it grows or during retirement. If he's lucky enough to have $1 million, it will be his free and clear -- a much better approach than paying taxes every year on $5,000 in a taxable account. But pay attention to the rules: You can deposit up to $5,000 for your grandson in a Roth, but only in a year in which he's earned at least that much working. If your grandson earns $2,000 on a job this year, for example, you could deposit $2,000 in the Roth. If he earns $3,000 next year, add that to the Roth.