Investing for Children: Building a Portfolio from Scratch with Regular Small Savings

Most portfolios for children start out small and are built up with savings, gifts and government grants or payments that come in month by month or year by year. In that circumstance, there are a couple of important practical challenges to building a portfolio which also conforms to the principles set out in early posts of this blog - controlling costs and diversifying for risk reduction through asset allocation.

Challenge #1 - Initial Purchase vs On-going Costs
Investing a small amount poses the practical problem of gaining effective diversification at reasonable cost. Even with low fees at discount brokerages, a $10 trade on a $100 purchase is a 10% cost - much too great. And buying only one stock or bond provides no diversification.

Option A - Buy Mutual Funds
There are many, many choices of stock and bond funds which allow purchase at no fee but the annual on-going fees may be too high. There are Index funds with low on-going fees of around 1% as well as actively managed (which try to outperform the market) equity funds whose fees are typically around 2.5%.

Option B - Accumulate Savings and Buy ETFs
Save up $1000 in cash and the $10 commission now only costs 1%. ETFs compensate for this cost by typically having much lower on-going annual fees as low as 0.1% (for whole of market equity index funds). In addition to the original passive index funds, ETF choices have expanded to many varieties of stock and bond groupings: industry sectors, countries/regions, size of market cap, strategies (dividend, growth, bearish, leveraged etc) (see Stock Encyclopedia listing)

Challenge #2 - Diversification and Portfolio Size
Within a small portfolio, having a multitude of tiny holdings will probably be costly, difficult, time-consuming and not worth the effort to keep the asset classes in the proportions of the intended asset allocation.

Option A - Individual Holdings of Fewer Asset Classes
Keep it simple. Start with fewer asset classes, adding as the portfolio grows.

Account / portfolio of < $10,000
Four asset classes provide effective diversification:

• Fixed Income - such as a total market bond fund
• Canadian Equity
  
• US Equity
• International Equity - e.g. a fund based on the MSCI Europe, Australasia, Far East (EAFE) index

Portfolios of $10,000 - 25,000
Consider adding:

• Real Estate - typically done with a REIT fund
• Emerging Market Equity - the MSCI EAFE excludes dramatically growing but risky markets such as India, China and Russia

Portfolios of $25,000+
Individual stock and bond holdings become feasible as a large enough number can be bought to achieve reasonable diversification. Additional asset classes to consider:

• Real Return bonds
• US Fixed Income
• Commodity - again through various funds
  
• US Small Cap Equity
• US Value Equity

Option B - Buy Portfolio Fund of Funds
In this case you buy only one holding. The fund company does all the work of buying the different asset classes and keeping them in balance. The issues to examine: is the extra fee charged, anywhere from 0.25 to 1%, worth it (on a $10,000 portfolio that's $100 in extra fees per year) and is the asset allocation what you want. Both mutual funds and ETFs are available. See Bylo Selhi's list of ETFs here and no-load indexed portfolio mutual funds here. CanadianFinancialDIY compares two ETF growth portfolio funds from iShares and Claymore and finds both are reasonably good.