Teaching your kids the importance of saving and investing

— -- Q: My two young sons, both less than 10 years old, have saved over $1,000 and would like to try investing in stock. What's a good way to proceed?

A: It sounds like your kids are ready to graduate from the piggy bank to the stock market.

First, congratulations for some excellent parenting. Teaching kids, at such an early age, to save is a great skill that's often overlooked. The fact your kids have accumulated $1,000 before their ages hit the double digits is something you should all be proud of.

And the fact they're interested in investing shows you've taught them another important lesson: Doing nothing with money erodes savings. Kids often worry most about their money's safety. They lock up their savings and hope to protect it. But as your kids apparently understand, locking up savings isn't necessarily the best thing to do.

Each year, the purchasing power of money falls by about 2% to 3%. That slow erosion of the value of money could quickly eat up the value of your sons' savings. Even people much older than your sons sometimes have trouble understanding that hiding cash isn't always the prudent thing to do.

The next question, though, is how to proceed in getting your kids interested in investing. I'm assuming you're not trying to train your kids to be day traders, but rather, how to build a prudent long-term portfolio that will generate healthy returns over time. It's a big chance for a teaching moment.

The first thing you might consider is teaching your kids how to keep dry powder. Explain to them that the stock market is risky, which is fine, since risk is what will make their money grow over time. But risk can also be unpredictable over the short term. Investors should never put money they need in the next three to six months in the stock market, since returns can be so unpredictable. You might show them how to figure out what money they will need over the next six months to a year. That money, which you can call savings, shouldn't be invested in stocks and should be parked in a savings account.

This whole exercise will teach your kids a few things. It will help them understand that investing is a long-term thing, where you put money in and then don't expect to touch that money for many years. It will also help them understand how budgeting and saving can work together.

Once your kids know how much they want to invest, it's time to understand how to invest. With kids, there are two schools of thought. There are merits to both approaches, and it's up to you to decide which one you like best:

•Choosing investments of interest. An easy way to get kids interested in investing is by letting them buy pieces of companies they know. Disney stock, for instance, is very popular with individual investors and their kids since it's a beloved brand. Investing in individual companies helps kids understand what stock is and what ownership means. You can also take this approach to teach the ideas of valuation, such as P-E ratios, as well as the basics of reading financial statements and the importance of dividends.