NOTE: This post is part of an ongoing education series. This information is for educational purposes only. This information does not constitute investment advice. No rational person would make investment decisions based on a blog post. Please consult with your financial advisor before taking any action. If you think it is OK to make investment decisions based on a blog post, then for the love of the FSM – Stop reading my blog.
Thanks to Friendly Atheist for the story idea and Image below.
One of his readers received this from his bank. Clearly “pray for money” is a bad strategy but, so are some of the others listed below.
Here are a couple of different ways you can save for college.
Save for college with cash, savings account or money market funds.
Current savings account rates are less than 1% and most money market rates are also below 1%. However, there is a chance that a Money Market account could yield 2-4% in the near future. These are safe investments but they bring very little return. So if your child is now 9 years old and you need the money at age of 19, your 2% per year compounded yearly would have a total return of just22%. So unless you start very early you will have to save the vast majority of what you will need to spend on college.
Saving for college with bonds
You can get a better return (with a little more risk) by choosing something like the Vanguard Total Bond Market Index fund. The 10 year average historical return was about 6% per year. Just to be safe I would only plan on making an average of 5% per year over the next 10 years. However, your compound return over the next ten years would be about 63%. Clearly quite a bit more than the 22% you would get in a good Money Market fund.
Saving for college with the stock market
If you invest in the stock market (s&P 500) you could make 10% a year. This is the long term average. However over short time frames (less than 20 years) anything can happen. The last 10 years the market was down a total of 20% (loss of about 2% per year – yikes). The previous 10 years the market went up over 300%. If you get the average of 10% a year you would make a compounded return of 160%. The problem is, there is no way to know in advance if the market will go up or down.
Saving for college – a hybrid method!
My favorite way to save for college for your kids is to take care of your retirement investing first. Max out your 401(k) your IRA, save and invest in your own accounts and act like a long term investor. When your child is 0-8 years old keep investing like it is for your personal retirement. During this time you may get lucky and make the long term market average of 10% per year.
When your child reaches the age of 9, start to move about 10% of the amount you expect to contribute to their education to a more stable option like the Total Bond Market Index Fund mentioned above. Of course you should try to keep saving more money during this time. If at any time the stock market takes a big hit you can postpone moving funds for a year or two. If you have a really good year in the stock market, feel free to move 20%-30% over to the stable position. This will allow you to lock in returns of the really good years and give you some time to recover from the bad years. When your child is around age 19 you should have most or all of the money you expect to use for college in the more stable position. This strategy allows you to maximize your gains in the market and provides extra protection as college age approaches. In the dream world of assumptions you will get around 10% per year from the market at the start and 5% per year when it is time to pay the bills. Assuming that your returns would go down from 10% to 5% at the decreasing rate of .5% a year (this is a lot of assuming) your total return for the last 10 years would be around 110%. This is a large percentage of the 160% you could have had if you stayed just in the stock market but a lot less risk.