How to Invest for a College Education

Planning for college these days is like trying to turn a molehill into a mountain.

The mountain is the amount of money parents will need in order to put a child through college a decade or two down the road. The molehill is the sum of cash most people typically start out with.

But with the right investments, enough time and ample discipline, financial miracles can happen.

Suppose you invest $250 a month and earn 8% annually, a conservative figure given the stock market’s long-term average of about 10%.

After 18 years, that sum would mushroom to about $120,000 (ignoring taxes), which is about what four years at a public university will cost in the year 2010, according to the College Board in New York.

That estimate includes tuition, room, board and other expenses.

A private-school degree will set you back more like $260,000, the College Board figures, requiring a monthly investment of about $540.

Cost estimates that far in the future are prone to inaccuracies, since nobody knows how much education expenses will rise in the meantime. Besides, your child might be able to rely on loans, scholarships and other assistance to ease the burden.

But there’s little question that higher education will be costly in the coming century: It is already. Anyone hoping to build a college cache should get started immediately, and mutual funds can help.

“The key is to take that first step,” says F. Bill Billimoria, president of Integrated Finances, an investment advisory firm in Arlington Heights, Ill. “Mutual funds are among the investments that make most sense for college planning.”

Here are some of the reasons why:

* Low-cost purchases. You can become a shareholder in most funds with as little as $500 to $2,500--a fraction of what it would cost you to build a portfolio of individual stocks or bonds. Plus, you can buy additional shares, typically in minimum increments of $50 to $250.

“We like to see clients make purchases on a monthly basis, straight out of their paychecks,” says Don Wilkinson, president of FSC Advisory in Irvine. “Mutual funds are a handy way to become methodical about accumulating money.”

* Diversification. The vast majority of mutual funds hold anywhere from a couple dozen to a couple hundred stocks or bonds. With such widespread exposure, funds will tend to track the broad markets over time--an important assurance for long-term investors.

With individual stocks and even some bonds, there’s no way to predict where their prices might be years from now if the company gets into trouble along the way.

* Range of investment choices. Most fund families offer one or more stock, bond and money market portfolios, and the majority allow no-cost transfers or switches between funds. This makes it easy to diversify among asset categories, if you choose.

* Automatic reinvestment of dividends. Over time, your account will grow much more dramatically if you plow back your dividend or interest income into additional shares. Fund companies fully credit all reinvestments to the nearest thousandth of a share. Try buying such a small fraction of an individual stock or bond.

So which types of funds make the most sense for college planning? The answer depends in part on the age of the child, the parents’ risk tolerance and tax considerations. But in general, stock portfolios are the vehicles of choice. That’s because people investing for college typically have several years to do so, and over long periods stock products leave bond investments in the dust.

“You would want to have the overwhelming majority of your assets in growth rather than income funds,” Billimoria says.

That sentiment is echoed by Edward T. Gesten, a senior vice president for Shearson Lehman Bros. in Phoenix. He often starts unsophisticated clients in bonds to get them comfortable with the financial markets but soon has them move most of their money into stocks.

“With inflation so low, you can make a good case for fixed-income investments, but equities have historically outperformed bonds and should be the core component” of a college portfolio, Gesten says.

T. Rowe Price Associates, a Baltimore-based fund company, suggests growth, international or small-company portfolios for college-bound youngsters at least five years away from matriculation.

At the five-year stage, “You should start switching that portion of your savings required for first-year expenses . . . into lower risk, midterm investments like bond funds,” reads the company’s free college-planning guide.

“At the two-year mark, start shifting money into short-term investments to create a pool of ready cash you can draw on as needed.”

When it comes to college planning and the considerable expenses involved, the biggest ally new parents have is time--and the major obstacle, discipline.

“When the market’s going down, it can be emotionally difficult to keep putting money in, but you need the discipline to do so,” Billimoria says.

Gesten agrees. “You should have a plan, monitor it, adjust it when needed but stick with the basics,” he says. “Don’t let emotions derail your long-term goals.”