The Principal is Your Friend

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.

"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% to $35,504 in just two years -- $15,000 no longer available for tuition and other 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.

Book smarts

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% or 20% hit."

Individual investors, often working with a financial adviser, have extensive latitude when it comes to college-savings strategies. Yet such autonomy can disadvantage investors if they delay safeguarding college-bound cash.

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 six years old. By 10 years of age, 60% of the portfolio is in stocks and 40% is in bonds. At 13, that 60-40 split reverses, and by 16 -- two years before college -- the account holds just 20% in stocks and 80% in bonds. Once in college, the stock portion drops further -- to 10% of assets.

"People in 529 plans saw that work very effectively during the down-market years," said Joseph Hurley, founder of the Savingforcollege.com Web site. "Their older children were pretty well protected from the stock market in 2000 and 2001. They didn't have that exposure because they'd selected the age-based option."

Safe strategy

If you're a do-it-yourselfer, here's what many investment experts recommend:

Freshman year in high school leaves four years before college. At that point, take enough money out of stocks to cover freshman year of college. Invest the proceeds in a Treasury note or a bank certificate of deposit that matures in about four years, when you'll need the cash.

Then every year for the next three years, sell another year's worth of college costs from stocks. By the time your kid is dealing with college freshman requirements, money set aside for the next four years of education will be solely in bonds or cash.

"I wouldn't go to all cash as my kid hits freshman year in high school, but I'd make sure I had freshman year in college available," Ellman said.

"You're trying to earn some money but keep principal intact," added Kays. "Safety becomes an issue."