||Balance Risk and Return for College Costs
Building a college nest egg can take some time,
which means that your investment strategy must change depending on
where your child is on the road to college
With college tuition soaring ,
parents who want to pay for
their kids' education need as much help as they can
get. Tax-advantaged education accounts and
are a huge help, but by far the best thing for college savings is
time. By starting to save for college early, you can invest in stocks
and earn returns that keep up with or exceed college tuition
increases. However, stocks are risky for the short term , so you must move your
savings into safer investments as your child gets closer to college
Get a Head Start on College Costs
If you're an overachiever, you
can start setting
money aside for college before your bundle of joy is even a glimmer
in your eye. For many parents, the birth of a child is a wake-up call
(even several a night for many months). As the costs of raising an
infant begin to roll in, you might forget about the college costs
looming decades in the future. However, these early years are great
for getting ahead of the college curve. Start investing money
regularly in mutual funds that own stocks. Because of the number of
years you'll have to save and the higher returns
that stocks or stock-based mutual funds provide, your monthly
contribution can be more reasonable, as demonstrated in . With 12 years of investing at a 10 percent
return, you need about $350 a month to reach $100,000. If you
don't start saving until five years before school
and use safe investments paying 4 percent return,
you'll need $1500 a month to reach the same goal.
Figure 1. The earlier you start to save, the less you have to contribute each month to reach your goal
Stock-based mutual funds are the easiest investments for this kind of
savings plan. You can set up an automatic investment program, so that
the mutual fund deducts your monthly contribution automatically from
your checking account. When it's time to sell some
of your stock investments, you simply sell the appropriate number of
shares of the fund. You won't have to consider which
stocks to sell or how to rebalance the stock portfolio for
To make the most of compounding, be sure to reinvest the dividends
that your stocks or mutual funds distribute.
The Middle Years
The adolescent years bring a host of problems, both psychologically and
financially. You're on your own interfacing with
your teenager. Fortunately, the financial transformation of college
savings will seem easier by comparison. Because you
don't want to lose money in the stocks in your
college savings when there's little time for them to
recover, the transition to safer investments begins when your child
is 12 years old. The conventional advice is to start depositing new
savings into safer investments, such as long-term certificates of
deposit or zero coupon treasury
bonds (also known as zero-coupon treasuries) that mature
when your child heads off to college. However, if you make automatic
monthly deposits to a stock fund, you could choose to continue that,
and sell a chunk of your stocks or mutual funds to meet your target
percentage for CDs or bonds. However, if a recession appears
imminent, switch your monthly deposits to a secure savings option.
A zero coupon bond does not pay interest during its lifetime.
Instead, investors buy zero coupon bonds at a deep discount from
their face value, which is the lump sum the investor receives when
the bond matures. In addition to higher rates than bonds that pay
interest regularly, zero coupon bonds usually carry long terms such
as eight or more years, so you can purchase zero coupons that mature
exactly when you need money for tuition.
By the time your child is 14, about half of your college nest egg
should be in safer investments. Therefore, between ages 12 and 14,
you must gradually reduce the percentage of funds invested in stocks
from 100 percent to 50 percent. Realistically, you continue to reduce
the percentage of money in stocks until all your college savings are
safe by the time your child heads off to college.
Using CDs, traditional bonds, or zero coupon bonds for your secure
savings also requires some planning. You want sufficient holdings to
mature each year. In addition, if you decide to add your monthly
contributions to safe investments, you could end up with numerous CDs
for each contribution. Small bond purchases could kill you with
minimum commissions .
Here's one approach to keep things simple:
When you transfer money from stocks to safe investments, buy a
fixed-income investment that matures in time for freshman year.
Continue using stock transfer dollars to buy fixed-income investments
that mature for freshman year up to the amount you forecast for
freshman year expenses.
When freshman year is covered, start buying fixed-income investments
that mature for sophomore year until sophomore expenses are covered.
Continue this approach to cover junior and senior years.
When you want the monthly contribution to go into safe savings,
deposit the monthly contribution in a money market account, money
market fund, or savings account with a decent interest rate.
Twice a year, use the money in the money market to purchase
fixed-income investments that mature for the college year that
isn't yet covered.
Hacking the Hack
Unfortunately, the money you invest in stocks grows faster than the
money in safe investments, and the monthly contributions further
unbalance your plan. Trying to figure out how much money to transfer
between stocks and safe havens each year might give tax preparation a
run for its money as something you'd rather not do.
That's why it's a good idea to
create an Excel spreadsheet to help you plan your college savings
The spreadsheet in assumes a steady
monthly contribution from the time your child is born until she
graduates from college. $400 a month adds up to well over $200,000
when you save for 22 years. So, sending your child to a good, private
school requires nothing more than saving the money you would spend on
a cappuccino on your way to work and eating lunch at a restaurant
Figure 2. Calculate the money you should invest in stocks and fixed-income investments to reach your goal
The spreadsheet uses the Future Value
(FV) function to
calculate how much your savings grow to over time. shows the FV function
calculating the result of saving $400 a month for the first 12 years.
This example starts with a zero balance, so the present value
parameter is zero.
Example 1. The formula to calculate future value from a zero balance and monthly contributions
Future Value from stocks = FV(B$2/12,(B$3+B6)*12,D$3,0,)
Here's how the FV function works:
Future Value = FV(rate,periods,payment,balance,type)
The interest rate per period. Because the return rate in cell B2 is
an annual rate, the rate parameter in this example
divides cell B2 by 12 to obtain a monthly rate.
The number of periods you plan to save. Because the function in cell
C6 calculates 12 years of return (the number of years of saving in
cell B3 minus the years before college in cell B6), the number of
periods equals 12 multiplied by the number of years.
The monthly contribution.
Known as the present value, this is the amount of money you have at
the beginning of the savings period, in this case, zero.
For a savings plan, enter 1 as the type parameter. This calculates
the future value assuming that you contribute at the beginning of
When your child reaches age 12, the example switches to yearly
calculations. In this example, the monthly contribution goes into
stocks, so the formula for calculating the future value takes into
account both monthly contributions and the balance at the beginning
of each year, as shown in .
Example 2. The formula to calculate future value from an existing balance and monthly contributions
Future Value (cell C9) = FV(B$2/12,12,D$3,-K8,)
In , the balance or present value is the
amount of money in stocks the previous year (cell K8).
The spreadsheet performs several calculations to determine how much
money you need to transfer to safe investments each year:
- Safe Nest Egg
Use the FV function to calculate the value of your
safe investments at the end of a year using the safe return in cell
B3. Beginning the freshman year of college, the monthly contribution
is made to safe investments, so it appears in the payment parameter
in these cells.
- Total Nest Egg
The total amount of savings you have at the beginning of the year.
- Withdrawal from safe
The amount of money you must withdraw to pay for a school year. This
value is zero until freshman year, and then increases by about 10
percent a year until graduation to take into account potential
tuition and board increases.
- Remaining Nest Egg
The savings that remain after withdrawing money for a school year.
- Target stock %
The percentage of savings you want in stocks at the beginning of the
year. This value drops each year until freshman year of college, at
which point all savings should be safe.
- Target safe %
The percentage of savings in safe investments at the beginning of
- Transfer to safe
The amount of money you should transfer to safe investments after any
withdrawals to meet your target safe percentage. To calculate this
value, subtract the amount of money in safe investments from the
target safe dollars, and then add in the value of any withdrawals.
- Target stock $
The dollars you want in stock investments to meet your target stock
- Target safe $
The dollars you want in safe investments to meet your target
The returns you achieve don't always match your
forecasts. Because the returns you supply for calculations are
average annual returns, your year-to-year results almost never match
your estimates. For that reason, when you get to the beginning of
each year processed in your spreadsheet, replace the values for
stocks and safe investments in columns C and D with the actual
balances in your accounts.
© 2007 O'Reilly Media, Inc.
| Customer Service:
| Book issues:
All trademarks and registered trademarks appearing on oreilly.com are the property of their respective owners.