(MONEY Magazine) – Please sharpen your No. 2 pencils and prepare for the ACT--the Awful Costly Truth, that is. Your child's college education will require: a) four times more than the cost of your first car, b) three times the bill for a 300-guest wedding and a honeymoon, c) double the down payment on your house, or d) the sum of all of the above. If you chose d, congratulations. We can only hope your child performs as well on his or her college entrance exams. The fact is, if analysts are right and tuition continues to rise 6.5% a year, sending a child to a public college in 18 years will cost roughly $115,000, and to a private school around $250,000.

Okay, next question: The best way to prepare for these account-crushing bills is to: a) rob your kid's piggy bank and invest the money in ostrich farms, b) stuff as much as you can in stocks and bonds, or c) put your money under the mattress--and, while you're at it, hide there too.

Hint: When in doubt, always circle the letter b.

Good choice. No matter what wild schemes you may conjure up in the dark of the night, a steady investing strategy is the best way to prepare for college bills. The exact approach you should take, however, depends on your child's age. That's why this story describes how to invest if your child is 10 or more years from college, half a dozen years away or on the brink of facing the ACT or SAT exams. Before you jump to the section that fits your time horizon, however, consider these guidelines:

Start saving now. Anup and Channing Patel, pictured on page 51, have already put away $10,000 for their two-year-old son Nathaniel's college education. Smart move. If you begin investing $443 a month when your child is five and your investments average an easily achievable 7% a year, you'll have enough for his or her tuition, room and board at a private school in 2008 to 2012. If you wait until your child is 10, you must invest $607 a month. Start when your kid turns 14 and you'll have to sock away a staggering $886 a month. To determine how much you must save, turn to the worksheet on the next page. If the amount seems painfully unattainable, start with $50 or $100 a month. Then step up your savings as your family income rises.

Go for growth. You must funnel most of your savings into stocks. Seemingly safe investments, such as bank certificates of deposit, Treasury securities and U.S. Series EE savings bonds, simply don't keep up with hikes in college tuition. By contrast, over the past 18 years, Standard & Poor's 500, a widely followed index of large-company stocks, has gained an average 14.3% annually, outpacing tuition inflation by roughly eight percentage points. Moreover, while share prices sometimes swing alarmingly, stocks haven't lost money in any eight-year holding period since World War II.

Make investing easy with mutual funds. They offer professional management, risk-reducing diversification among different securities and easy reinvestment of interest, dividends and capital-gains distributions. Boasts Peggy Ruhlin, an accountant and financial planner in Columbus, Ohio who invested in stock funds for her daughter's college bills: "My original investments paid for two years of education, and the funds' returns paid for the other two." Moreover, most fund companies offer automatic investing programs, in which you can authorize them to transfer a set amount from your checking account to one or more funds each month or quarter. To help you get started, fund companies such as Oppenheimer, Twentieth Century and T. Rowe Price lower minimum initial investments for automatic investors and sometimes waive sales commissions, called loads.

Be wary of investing in your child's name. Currently, a child's first $650 in investment income is tax-free and the next $650 is taxed at his or her rate, usually 15%. Anything over $1,300 is taxed at your rate until your child turns 14. Before rushing to take advantage of those tax savings, though, keep in mind that investing in a child's name may disqualify your family for need-based college financial aid. That's because the formulas used in parceling it out require a child to contribute as much as 35% of his or her assets toward school bills, while parents are expected to pony up only around 6% of theirs.

If you don't think your family will qualify for aid, however, go ahead and save in the child's name--at least enough to generate as much as $1,300 in investment income until age 14, and more after that. When the child is 14, all of the investment income is taxed at his or her rate, not yours.

Finance your retirement first. There's good reason for giving priority to saving for your own retirement. For starters, money in tax-free savings plans such as 401(k) plans and Individual Retirement Accounts will grow more quickly than anywhere else. Second, retirement plan balances aren't counted in financial aid formulas. Besides, do you really want to live in your kid's basement when you get older?

With those general pointers in mind, consider the following specific investment advice for children of various ages. And once you decide on the right combination of stocks, bonds and cash investments for your college savings, turn to the table of 75 top-performing mutual funds on page 54 to choose the ones that suit you best.

GROWTH SPURTS: NEWBORN TO AGE 8

If your child is eight or younger, financial advisers recommend that you go all out for growth by stashing 75% of your college money in stocks. The reason: While growth-oriented stock funds are subject to price swings that historically average nearly 16%, you have time to live through such ups and downs and benefit from stocks' historically high average returns.

If you've never invested in a fund, Susan Belden, senior editor of the monthly newsletter No-Load Fund Analyst ($195 a year; 800-776-9555), recommends that you start with a fund that has some international exposure and a manager with a strong track record. Her choice: Mutual Qualified (no load; $1,000 minimum investment; 800-553-3014). The conservative growth and income fund has raked in 15% annual gains over the past decade, yet it's 33% less risky than other funds of its type, according to Chicago fund rater Morningstar.

Once you have several thousand dollars saved, you should begin to diversify among as many as five funds of different types. "You want to be in more than one asset class, because you'll get a better return for the risk you take on," explains Pittsburgh money manager Roger Gibson, author of Asset Allocation: Balancing Financial Risk (Irwin Professional Publishing, $45). He suggests investing in domestic stocks first, since that should be the largest asset class in your portfolio, then adding domestic bonds for balance, international stocks, real estate securities and international bonds.

In dividing up your money, financial advisers urge you to invest as much as 18% of your college savings in funds that hold shares of medium-size companies (known as midcaps because they have market capitalizations of $1 billion to $5 billion) and large-cap firms (capitalizations of more than $5 billion). Another 18% should go into funds that specialize in small companies and 24% more in funds that invest in international companies of all sizes. The reason for this diversification: Gains in one category can offset losses in another, so your overall portfolio will perform more evenly.

Finally, select funds with managers who follow different investment philosophies, since stock-picking techniques fall in and out of favor, depending on the market. (We give the investment philosophy of the funds in our table in the columns headed Type and Style.)

Don't be overly conservative in choosing your funds. For example, Anup and Channing Patel, both in their thirties, have $5,000 in a domestic-stock fund for Nathaniel's college education, plus $5,000 in Series EE savings bonds. "But the rate of return barely matches the rising cost of the schools," complains Anup, who earns $48,000 providing microcomputer support for a research program at Johns Hopkins Medical School in Baltimore. To boost their return, the Patels must invest more money in domestic and international stock funds and less in savings bonds, says Gibson. (See the model investment portfolio above that he has designed for the Patels and families like them.)

Why invest money abroad? Simply because foreign markets offer some of the world's best opportunities for growth, says Gibson. What's more, since foreign stocks don't rise and fall in lockstep with U.S. equities, the international investments will decrease your portfolio's overall risk.

Additionally, Gibson advises the Patels to invest 15% of their money in real estate securities. "It's a major world-asset class, so to be well diversified, investors should include it in their portfolios," he explains. He recommends Fidelity Real Estate Investment Portfolio (no load; $2,500 minimum; 12.7% average annual return over the five years to June 30; 800-544-8888). Manager Barry Greenfield, 60, targets REITs (real estate investment trusts) with steady earnings growth of 3% to 7% that own apartments, shopping centers, industrial buildings, malls and factory outlets. Gibson also favors Templeton Real Estate Securities (5.75% load; $100 minimum; 8.8% average annual five-year return to July 1; 800-292-9293), which invests nearly half of its assets in real estate securities abroad and the rest in the U.S. "It's probably the most conservative fund in the bunch, because of management's attention to diversity and value," he says. Another of his picks is Cohen & Steers Realty Shares (no load; $10,000 minimum; 800-437-9912), which has the highest average annual return of all real estate funds (14.2% since its July 1991 inception). The fund invests mostly in REITs that own apartments, malls and shopping centers. (You can lower the fund's steep minimum initial investment to about $2,000 if you invest through discount brokers such as Charles Schwab or Fidelity.)

Finally, to soften any huge price swings in your stock funds, Gibson urges you to keep 25% or more of your college money in domestic and international bond funds. (Bonds can gain value when stocks fall.) For example, he recommends that the Patels invest 10% of their money in short-term bond funds with maturities of two to four years, 9% in intermediate-term bond funds with maturities of five to 10 years and 6% in international bond funds. While some experts say that international bond funds don't offer high enough returns for the risk you must take on, Gibson says: "A well-diversified portfolio should have allocations across all major world-asset classes, and international bonds constitute about 28% of worldwide capital." What's more, he says, "International bonds mitigate risk, because they don't perform in sync with U.S. stocks and bonds."

BALANCING ACT: AGES 9 TO 13

As college draws closer, you should invest a little more conservatively, gradually scaling back your stock holdings. For instance, Gibson urges Susan Hough and Lee Slice of Arcadia, Calif., pictured above with Sarah, 11, Joshua, 8, and Paul, 4, to put only 60% of their savings in stocks. The reason: Sarah is just seven years away from college. "The shorter the time horizon, the more you need to start backing away from equities," explains Gibson. "You have to trade off the possibility of high returns for greater predictability of outcome."

At this point, you have a choice: You can stash your money in one or more balanced funds, which keep roughly half of their assets in stocks and half in bonds. Or you can continue to hold separate stock and bond funds but move money from small-company stock funds to less volatile large-company funds. "That way you'll be more conservative but not so conservative that you lose growth altogether," says Lisa Osofsky, a financial planner for M.R. Weiser & Co. in Iselin, N.J. Another less volatile option: Buy equity income funds. By seeking income as well as capital gains, these funds cushion you against market downturns.

Hough and Slice, both 34, have saved $4,600 for each of their children in an equity income fund. The parents both have Ph.D.s--Susan is a seismologist with the U.S. Geological Survey, and Lee is a biochemist on the research faculty at UCLA-and a combined income of about $100,000. Says Susan: "I would like my children to do whatever they want to do." To help make that possible, Gibson would rearrange the family's college investments, creating separate portfolios for Paul and Joshua with more money allocated to stocks. (See the portfolio on the facing page.)

NEARING THE FINISH LINE: AGES 14 TO 18

By now, your family is getting close--perhaps uncomfortably close--to planning college visits, taking SAT or ACT exams and paying your first tuition bill. Your top priority: Keeping your college money safe and liquid. During these last few years, begin transferring money from stock funds to short-term bond and money-market funds. "When a child is four years away from college, I would begin to move 25% of the portfolio a year into safer investments," says Ruhlin. "By the time the child is in college, just about all of the money for his or her schooling should be in CDs, short-term bond funds, Treasury bills or notes or money funds. That way if there is a stock market correction, the parents won't have to worry."

Another option is to buy short-term zero-coupon bonds (from a bank or broker) that mature before each tuition bill. Unlike regular bonds, zeros pay no interest. Instead, you buy them at a substantial discount from the face value you will collect at maturity. For example, a zero that will pay you $1,000 in the fall of 1999 might cost around $785 today. Zeros are issued by the U.S. Treasury, corporations, states and municipalities. Since the prices of long-term zeros are extremely volatile, make sure you can hold the bonds until maturity. Otherwise, if you cash out early when interest rates are rising, you could lose money.

What if your kid starts school this fall and your good intentions never made it to the bank or brokerage? You may take a little solace in the fact that you're not alone. Consider the MacDonalds of Cataumet, Mass., pictured below and on pages 48 and 49, who have no college savings whatsoever despite a $140,000 annual income. Bruce, 45, who owns and runs a moving company, and Grace, 34, an international financial analyst for the Gillette Co., will send their oldest child--Bligh, 18--to St. Anselm's in Manchester, N.H. this fall. Total annual cost for room, board and tuition: $19,570. Then, in the fall of 1996, Clayton, 16, will start his freshman year in college. A few years later, the MacDonalds will face college bills for Alexander, 13, and eventually for Bruce, 1.

Fortunately, the MacDonalds are debt-free and have substantial home equity, as well as $150,000 in Grace's 401(k) savings plan. They don't want to take out a loan on their house, however, and Philip M. Gallagher, a financial planner and co-owner of Allegheny Financial Group in Pittsburgh, urges them not to borrow against their retirement savings. "If they borrowed $50,000 from the 401(k), Grace would be giving up the chance to invest in equities," says Gallagher. "Since she's only 34, for Grace to enjoy Bruce's retirement and not have to work until age 65, she needs to keep the 401(k) going."

Instead, Gallagher recommends that Bligh start out by borrowing the $2,625 maximum under the federal unsubsidized Stafford Loan program. He also suggests Bligh help pay his bills by earning $1,500 during the school year with a campus job and $1,500 with jobs during summer and Christmas holidays. In addition, Gallagher advises the parents to borrow $14,000 a year under the federal Parent Loan to Undergraduate Students (PLUS) program. (All loan requirements and terms are explained in "Low-Cost Loans to Pay Your College Bills" on page 56.)

Of course, following Gallagher's advice will require Bligh and his parents to take on about $17,000 in debt for each of his four years in college. The last three years will also be ones in which Clayton will be attending college. To educate both kids will require the MacDonalds to borrow at least $140,000, not to mention the loans they will need to educate Alexander and Bruce.

And that, friends, is the predicament you can find yourselves in if you delay saving for college. Says Bruce: "You'd think we would have seen it coming, but we're baby boomers. We never thought we'd get old."