Investing for college calls for prudence

Increasing caution becomes important as children approach college age.

MARKETWATCH

SAN FRANCISCO — Investing for a child's college education? You better know when to drop out.

Ideally, saving for college begins early in a child's life so the money can grow over time, preferably in a diversified portfolio of stocks. This aggressive approach — with its potential for high return — is crucial to amass enough cash to cover the spiraling cost of a four-year education.

Dutiful moms and dads get top marks for anticipating their child's higher-learning needs, contributing to separate college accounts or utilizing state-sponsored 529 college savings plans. Yet most parents don't realize that all their careful handiwork could unravel if stocks suffer a severe downturn on the eve of junior's freshman year.

Risk factor

"The stock market is the best place to accumulate wealth over a long period of time, but it can be very volatile in the short term," said Scott Kays, an Atlanta-based financial adviser. "What you don't want to do is have to pull money out in a downturn."

Here's why: Suppose you'd invested in the Vanguard 500 Index Fund in July 1990, shortly after your child finished kindergarten. The Vanguard fund offers broad exposure to the biggest U.S. stocks — seemingly tailor-made for college 12 years later. Indeed, a $10,000 investment would have grown to $50,920 a decade later, according to investment-research firm Morningstar Inc.

With two years left until college beckoned, and coming off a bullish period, it would be tempting to keep the money in the market. But doing so is risky; there's too little time to recover from stiff losses.

Look at what happened to the Vanguard investment. By the end of June 2002 — high school graduation in our example — the fund had stumbled badly, whipsawed by the worst bear market in a generation. The account's value declined 30 percent to $35,504 in just two years — $15,000 no longer available for tuition and expenses.

Moreover, retracing lost ground can take years. The Vanguard investment, for example, was worth about $45,000 as of June 30, still less than its value five years ago.

Conventional wisdom cautions against putting into stocks any money that you'll need within several years. This also applies to college.

"It makes sense to get more conservative as you approach any investment target," said Kevin Ellman, a financial adviser at Wealth Preservation Solutions in Ridgewood, N.J.

Ellman suggests shifting stock exposure in favor of bonds four years before an expected major expense. "You might catch the cycle right," he said, "but you could just as easily catch it wrong and take a loss. Most people, if they're saving for college, don't have the cash flow to recover from a 10 percent or 20 percent hit."

529 plans

Participants in 529 college plans, in contrast, don't have as much leeway with investment choices. So discipline can make a big difference when it comes to principal protection.

Many plans allow self-directed annual changes to asset allocations. Plans also feature a rebalancing option that removes the guesswork. This age-based approach — typically "conservative" and "aggressive" in nature — automatically shifts the portfolio's percentage of stocks and bonds over time.

For example, Pennsylvania's 529 plan puts aggressive, age-based accountholders fully in stocks until the beneficiary is 6 years old. By 10 years of age, 60 percent of the portfolio is in stocks, and 40 percent is in bonds. At 13, that 60-40 split reverses, and by 16 — two years before college — the account holds just 20 percent in stocks and 80 percent in bonds. Once in college, the stock portion drops further — to 10 percent of assets.