College savings: Minimizing risk

When it's time to pay for college, it's time to start playing it safer with your child's future, says Money Magazine's Walter Updegrave.

By Walter Updegrave, Money Magazine senior editor

NEW YORK (Money) -- Question: We have money in an aggressive growth fund that's earmarked for college expenses. The time is now approaching when we'll need this money and we're thinking of moving it to a less volatile investment, such as a bond or money-market fund. How does one go about choosing such funds? - Becky Hill

Answer: Let me start by saying that you're doing the right thing to consider moving toward a less aggressive investing strategy as you get closer to tapping that college tuition stash.

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With the market doing so well over the past couple of years, I think a lot of people, whether saving for college, a house down payment or some other goal, began to think it was okay to invest money they would need within five or fewer years entirely or mostly in stocks.

After all, with the economy and the stock market humming, it appeared to be a risk-free proposition. Indeed, it seemed almost foolish to put your money anywhere else, unless, of course, it was real estate.

But although this notion never really made sense, the market turmoil of the past month and the deflating of the real estate bubble over the past year has revealed just how dangerous that reasoning can be.

What's more, recent setbacks in stocks and the fear that those losses may be just a taste of worse to come have re-acquainted investors with what I believe is a fundamental truth that's too often overlooked - namely, that no matter how attractive stock returns may be at any given moment and no matter how bright their prospects might seem, equities are primarily a long-term investment.

And the sooner you will need to tap the funds you are investing, the less of that money you can afford to have invested in stocks.

You don't say exactly when you must begin paying those college expenses. So I can't recommend a specific stocks-bonds-cash mix. But I can do the next best thing - that is, suggest you go to our Asset Allocator. Once there, you just answer a few simple questions about your time horizon (i.e., when you'll need the money) and your tolerance for risk, and you'll get a suggested stocks-bonds mix.

So, for example, if you'll need to start paying college bills within three to five years and you want to take a relatively conservative approach, our Asset Allocator will recommend that you probably should keep no more than 30 percent or so of your money in stocks and the rest in bonds.

As you draw closer to having to meet those college expenses, you'll want to move even more money out of stocks and also begin moving some of your stash into a very secure investment like a money-market fund. (You could also use a short-term CD or savings account. Unless there were a big difference in yields, however, I'd probably go with a money-market fund with check-writing privileges for the sake of convenience.)

Why not just keep your entire stash in bonds since they tend to pay higher returns than money-market funds? Well, although bond funds are certainly more stable than stocks, they can also lose some of their value, primarily because bond prices slide if interest rates rise.

Money-market funds, by contrast, invest in very short-term debt obligations that are extremely unlikely to decline in value even if interest rates spike up, which is why money funds are considered the equivalent of cash. So when you're ready to begin actually shelling out cash for tuition and other expenses, the money you use should probably be sitting in a money-market fund.

Just how quickly you want to move entirely out of stocks and - once that's done - how you should divvy up your money between bonds and a money-market fund depends two things: personal preference and how much wiggle room you have in paying college bills if your investments came up a bit short.

Generally, though, I'd say that by the time you're within two years of paying the tab for college, you would probably want to be out of stocks entirely.

By the time you're ready to lay out that first year's tuition and other expenses, you would likely want to have something like 75 percent of your money in bonds and 25 percent in a money-market fund (and certainly enough in the money-fund to cover at least that first year's worth of expenses).

Over the next few years, you can gradually move more into the money fund so that by the time you're ready to pay the last two years' tab, all or nearly all of your money should be in the money fund.

As for choosing a bond fund you should invest in, I have two suggestions. The first is that you should play it safe by sticking to bond funds with a short- or intermediate-term average maturities - that is, funds that own bonds that will mature within two to eight years. The shorter the bond fund's average maturity, the less of a hit it will take if interest rates rise.

I also recommend that you pick a bond fund with below-average annual expenses. As a rule, I don't think it makes sense to invest in a bond fund that charges more than 0.75 percent or so in annual expenses. (For more on how to evaluate bonds and bond funds - as well as specific bond-fund recommendations - click here).

When it comes to choosing a money fund, low expenses are also key. As a matter of convenience, you may want to go with a money fund that's run by the same fund company that manages your stock and bond funds, since that may make moving your money around a little easier. But in any case, I don't see any reason to invest in a money fund that charges more than 0.5 percent a year in annual expenses.

One final note: I want to stress that I'm not recommending that you move toward a more conservative mix just because stocks are going through a rocky patch at the moment. Fact is, it's precisely to avoid making this short of shift after stocks have taken a hit that I recommend that investors set an asset allocation mix ahead of time based on how soon they'll need the money and how much risk they're willing to take.

If you've failed to do that or if you've let stocks' gains in recent years lull you into a false sense of security so that you've now got too much of your portfolio devoted to equities, then I recommend you go to our Asset Allocator and re-assess your mix right now. Otherwise, you could find yourself in even more trouble down the road. Top of page

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Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer LIBOR Warning: Neither BBA Enterprises Limited, nor the BBA LIBOR Contributor Banks, nor Reuters, can be held liable for any irregularity or inaccuracy of BBA LIBOR. Disclaimer. Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.