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Investment Strategies

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The following investment strategies provide advice on how best to invest the money you are saving for college. You may also find the easy savings tips helpful in this regard.

Investment Strategies

  1. Start early. The best investment advice anyone can give is to start now. It is never too soon to start saving for college. Even the day the baby is born is not too soon. At 10% interest, money saved during the first year of a child's life is worth five times as much as the same amount saved the year before the child enrolls in college. The sooner you start, the less you'll need to save each year in order to reach your goal. If you start early enough, you can take advantage of investment vehicles that promise greater returns but which are too volatile for short-term college savings. Time is literally money; spend it wisely by saving early.
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  2. Begin with an aggressive strategy, and switch to a more conservative strategy when college comes closer. Choose your investments according to the number of years until enrollment and your tolerance for risk. For example, you might start with high yield high risk investments when the child is young, and gradually shift the college savings to lower risk investments as college approaches. This can be either through a change in the asset allocation, or a change in the nature of the securities in which you invest.

    When your child is young, you can afford to pursue investments that involve a little more risk but which promise a potentially greater return, since you have time to recover from mistakes and weather market downturns. (Since such investments are also less liquid, this will help you avoid the temptation to use the money for other bills.)

    When college approaches, however, you need to have the money in safer, more liquid form. You don't want to be forced to sell your investments at a loss, should the market drop, just because you need the money to pay for tuition. The choice of when to sell should be based on your evaluation of the performance of the investments, and not based on external factors. (Some families stick with low risk investments from the beginning because they don't want to deal with the complexity and stress that accompanies high risk investments. But given that tuition rates increase at about twice the inflation rate, you'll need to earn at least 7% to 8% after taxes in order to keep up with increases in college costs.)

    If the stock market plummets when the child is young, the percentage losses might be high, but the dollar losses are relatively small. That's because the family most likely has not yet saved a lot of money in the college savings plan. On the other hand, when the student is about to enroll in college or is already in college, there is much more money at risk and much less time to recover from losses. You should plan for the possibility of losses, since the stock market has historically had a big drop at least once a decade. Even so, overall returns on investment tend to higher than other savings vehicles if you have long enough of an investment timeframe.

    Thus a good overall strategy is to have a mixture of high and low risk investments and to change the proportion as college approaches, with an aggressive strategy when the child is young and a more conservative strategy when college is just around the corner.

    • When the baby is born, put 75% of the money in high risk investments and 25% is low risk investments. (Age 1-5)
    • When the child enters the 1st grade, put 50% of the money in high risk investments and 50% in low risk investments. (Age 6-10)
    • When the child starts the 7th grade, put 25% of the money in high risk investments and 75% in low risk investments. (Age 11-15)
    • When the child reaches the middle of the junior year in high school, put almost all of the money in low risk investments. It is important to realize any capital gains by December 31 of the junior year in order to not have them count as income during the financial aid need analysis. Note that if the investments are in a 529 college savings plan as opposed to a taxable brokerage account capital gains within the plan do not affect aid eligibility. (Age 15-18)

    Many state section 529 college savings plans offer age-based asset allocation portfolios motivated by such considerations. Such portfolios base their asset allocation according to either the age of the child or the number of years until matriculation. They tend to divide the ages into four to seven age ranges. A plan with four age ranges will switch the asset allocation in 25% chunks like the example given above. A plan with five age ranges will use 20% chunks, and one with six or seven age ranges will use 15% chunks. Some plans offer both a regular age-based portfolio and a conservative age-based portfolio, where the conservative portfolio starts off with moderate risk investments instead of more aggressive investments. About two-thirds of families invested in 529 college savings plans use some form of an age-based asset allocation plans.

    Another possibility is a particularly aggressive asset allocation strategy for a family with a newborn. This strategy starts with 100% of the investment in higher risk investments, such as a S&P 500 fund or a total stock market fund, and waits until the child reaches junior high school (7th grade, age 11) to begin shifting to lower risk investments at a rate of 20% per year. It changes the trajectory of the asset allocation curve to sustain a high risk, high return allocation for a longer period, recognizing that families who start saving sooner have more time to recover from market downturns than families who start saving when the child enters high school. It strikes a different balance between the need to lock in savings and the need to have a higher return on investment. None of the state 529 plans offer such an asset allocation strategy, so the parent would need to manage it themselves by choosing different percentages of the funds available in the plan.

    To illustrate how such an aggressive strategy increases returns, suppose that the high risk investment has a 10% return on investment, while the low risk investment has a 4% return. Assuming annual contributions of $2,500, the typical moderate-risk asset allocation strategy will yield $76,349 after 18 years, the equivalent of a 5.88% return on investment. In contrast, the aggressive asset allocation strategy will yield $88,397 after 18 years, the equivalent of a 7.41% return on investment. The risk of the more aggressive strategy is that it is more likely to suffer if there is a market downturn that affects only the high risk investment. For example, if there is a 20% drop in the high risk fund at age 9 instead of a 10% increase, the two asset allocation strategies will yield $64,268 and $60,427. So instead of having a $12,048 advantage, the more aggressive strategy has a $3,841 loss. Note that both of these strategies are much less aggressive than a strategy which uses 100% equities for all 18 years.

    An even more aggressive strategy involves stretching out the switch from high risk to low risk investments through the middle of the college years instead of completing it in the junior year in high school. This takes advantage of the tax-free status of a 529 plan longer and allows for greater long-term appreciation. It is, however, best for families that will not qualify for financial aid, since the 529 plan will still count as a parent asset if not fully distributed to pay for college costs during the freshman year. On the other hand, even middle income families can benefit from this approach if they seek to maximize the benefit from the Hope Scholarship and Lifetime Learning tax credits.

  3. Be aware of the risk associated with your investments.
    • Higher risk investments include individual stocks and mutual funds. (We recommend avoiding extremely high risk investments, such as stock options, hedge funds and futures, unless you are an extremely experienced investor and are familiar with all the risks of such investments.)
    • Lower risk investments include bonds and bond mutual funds, state prepaid tuition plans, short-term US Treasury Zero Coupon Bonds (such as US Treasury STRIPS), US Series EE Savings Bonds, Treasury Inflation-Indexed Securities, and FDIC insured savings accounts and certificates of deposit. (Zero Coupon Bonds are fixed-rate, fixed-return investment instruments. They are sold at a discount off of the value at maturity, and are guaranteed to be redeemed for that value if held until maturity.) Note that some bonds may involve principal risk if you sell the bond before maturity, because the value of the bond will go down when interest rates go up. (Savings bonds are not marketable securities, and so do not have such a principal risk.)

  4. Evaluate investment vehicles carefully before investing. Carefully evaluate all the various investment vehicles before deciding where to invest. For example, you might be told to invest in tax-free municipal bonds in order to minimize the tax bite. But you might be able to find a mutual fund that isn't tax-exempt but which has a higher yield after taxes. Similarly, growth funds might have a investing philosophy that seeks to maximize long-term returns, but the actual returns on other types of funds might be just as good. Although life insurance and annuity products are sheltered from financial aid need analysis, using them as an investment vehicle is not your best option, since the rate of return, after subtracting fees, commissions and other loads is often very low. Likewise, some of the section 529 college savings plans have very high sales charges (as much as 5% or 6%) and expenses, while others may be very low. Setting up a trust or using the Uniform Gift to Minors Act might save you a little on taxes, but significantly reduce eligibility for financial aid. So always compare investments based on the net return after all expenses including taxes are subtracted, and consider the impact on need-based financial aid. It pays to shop around.

    Remember that historical performance is no guarantee of future return, so you should choose funds based on what you think will do well in the long term, not which funds happened to do well last year.

    Good resources in this area include:

  5. Reevaluate your investments at least once a year. If you find that the assumptions behind your investment strategy are not correct or your risk tolerance has changed, you may want to change your investment allocations. Remember, you should not sell an investment just because the market is down, but instead based on how you feel the investment will do in the future. For example, if you have an investment which you expect to go down further in the future, you should sell it. On the other hand, if you have an investment that is down but which you expect to rise in the future, you shouldn't sell it just because it is down. (Of course, if your money is in taxable investments, you may want to realize a capital loss to offset gains for tax purposes. If you do this, beware of the wash sales rule, which restricts purchasing the same stock, bond or mutual fund within 30 days of realizing a capital loss.)

  6. Diversify your investments. Don't put all your eggs in one basket. If you invest in stocks, for example, it is better to invest in mutual funds, since mutual funds spread out the risk over many stocks. This prevents a significant drop in the value of one stock from affecting your entire portfolio. You might find mutual funds which try to mimic the behavior of the market as a whole, such as the S&P 500, to be a good investment strategy. Such index funds often have lower fees. Very few managed funds outperform the indexes on a long-term basis. Likewise, you may want to invest in a mix of stocks and bonds, so that your money isn't all in stocks, and keep some portion of the money in a money market account or savings account. You should choose approximately four to six different investments in order to minimize your downside risk.

    Some people will invest some of their money in a section 529 prepaid tuition plan as a form of diversification because the value of prepaid tuition plans tends to increase when the economy sours. Prepaid tuition plans are based on state public college tuition rates. When the economy sours, states tend to reduce their support of higher education, which forces public colleges to increase tuition rates.

  7. Save regularly. Investing a fixed amount of money at regular intervals (e.g., once a week, once a month) gets you the benefit of dollar cost averaging, a good investment technique. It also gets you in the habit of planning for your future. If possible, have it done automatically through payroll deduction or bank drafting (EFT), so that the money is taken out of your bank account before you have a chance to spend it.

    (The idea behind dollar cost averaging is to invest a set amount per month, regardless of the behavior of the stock market. It is a simple and automatic way of implementing the sound advice "buy low" because it buys fewer shares when prices are high, more shares when prices are low. Numerous studies have shown it to be more effective than trying to time the market.)

  8. Save in the parent's name, not the child's name. This will minimize the impact of the fund on need-based financial aid.

  9. Save in tax-advantaged savings vehicles. Section 529 plans offer many tax advantages. They allow your money to grow in a tax-deferred fashion, and qualified withdrawals are exempt from Federal income tax. Many states also exempt section 529 plans from state income tax, and may even give you a tax deduction for your contributions.

    If you are nervous about investing in stocks and bonds, and just want to preserve the principal while earning a modest amount of income, you should seriously consider using a section 529 college savings plan or a section 529 prepaid tuition plan. Most section 529 college savings plans offer a money market fund or a protected principal fund, and some even have a guaranteed option which protects the principal and guarantees a minimum rate of return (typically at least 3%). Section 529 prepaid tuition plans allow you to lock in future tuition rates at today's prices, and are typically guaranteed by the full faith and credit of the state. Another option is the CollegeSure CD from College Savings Bank, which bases its interest rate on an index of the annual increases in college tuition rates.

    Too many parents use taxable savings accounts and CDs as their primary college savings vehicle, letting taxes diminish the return on investment.

    Don't plan on tapping into your IRA to pay for college expenses. Although you can do so without paying a 10% penalty if the money is used for qualified tuition expenses, you will still be paying income tax on the withdrawal. Using your IRA will also limit your ability to take advantage of the tax credits for education (Hope Scholarship and Lifetime Learning) and the education tax deductions.

  10. Avoid capital gains starting two years before college. When college is two years away, move most of the money into safe investments, such as FDIC insured certificates of deposit or a money market fund. This will make the investment more liquid, so that you'll have the money available to pay the college bills. You don't want to be forced to sell a stock at a loss in order to pay tuition. Should you realize a significant capital gain when you sell the stock during the tax year before applying for aid, not only will the financial aid formulas charge you for having an asset, but they'll also treat the capital gains as income. You need to realize the capital gains early enough so that they don't affect eligibility for financial aid. (If you did realize significant capital gains the tax year before applying for financial aid, ask the college's financial aid administrator for a "professional judgment" review, on the grounds that the one-time capital gains is not reflective of award year income and that the formula is effectively double-counting them. Many financial aid administrators will use their authority to exclude such capital gains from base year income, if you ask politely.)

    When putting money in CDs, time the maturity dates to occur when you'll need the money to pay bills, such as the beginning of the semester, so that you won't have to pay an interest penalty for early withdrawal. One possibility is to keep a quarter of the money in a liquid asset account in case you need the money before a CD matures. Another possibility is to have a CD maturing every three or six months.

Other Tips

Before selecting a financial adviser, test their knowledge by asking them about the impact of college savings on eligibility for financial aid.

If you get divorced, make sure that your divorce settlement addresses the future college costs of the children. Most state divorce laws do not address college expenses, so take care that your divorce decree discusses paying for your children's college educations. According to a 1997 survey by Charles Schwab, only 9% of single parents expect their ex-spouse to contribute toward college expenses. Get some commitment written into the property settlement, whether it means putting some property in the child's name, giving the property to the spouse and directing him or her to use the property to pay for college expense later on, setting up a trust fund or directing a lump sum payment to a section 529 college savings plan or a prepaid tuition plan.

 

 
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