Investing for a college fund is vitally important. How you invest the money is almost as important as how much you save. A bad investment could leave you without any college savings. Consider the following guidelines to help you invest for your child's college savings-assuming you have at least 10 years before your child will finish college.
Take only low to moderate risk
Risk-taking increases expected returns, but also increases the probability of loss. Even with 20 years until your child finishes college, there may not be enough time to recover from big losses. Keep your college fund investments conservative.
Individual stocks, even mutual funds invested in stocks, may be too risky for most people. Virtually any stock can drop in value. Mutual funds that invest in stocks can drop dramatically - as we saw in 2008 and 2009. You don't want to have your college fund invested in stocks when the market tanks.
Mutual funds investing in bonds (debt owed or issued by corporations or governments), also known as "income funds," are more appropriate for college savings.Take care to avoid - at least for college savings - "high yield" funds, which invest in "junk bonds" whose issuers are at risk of not being able to make the payments on their debt. There are four fund types that make good sense for college savings:
Intermediate Government funds
Government bonds have virtually no credit risk - the U.S. Government will certainly make the payments-and modest interest rate risk. Although returns are modest, "Intermediate Government" funds, which invest only in treasury and agency bonds with maturities of less than ten years, are optimal college fund investments.
"Short Government" funds
These are also appropriate college fund vehicles, especially as college gets nearer. Such short term funds have low returns but the short-term nature of the investments eliminates much of the interest rate risk.
"General Short Term" funds
These funds invest in corporate bonds with maturities up to four years, making them candidates for college savings accounts. Such funds are subject to both credit risk - the risk that the company that borrowed the money can't repay it - and interest rate risk. Both of these risks are reduced somewhat by the short term nature of the borrowings.
"Money Market Funds"
These funds invest in assets that are so free of risk that the funds expect to maintain a price of $1 per share all the time. Money market funds are considered cash. As you start spending money for college, keeping some of your investments in money market funds protects you from the risk of loss.
Diversify your investments, but don't over diversify
It is wise to invest in up to three different mutual funds, remembering that by their very nature a mutual fund is a pool of investments and so they have some diversification built in. Investing in two different general short term bond funds won't improve your investment strategy much. Investing some of your money in Intermediate Government funds and additional funds in a general short term fund makes more sense. Within the last few years of investing, you may want to invest only in shorter term funds to reduce interest rate risk.
Bond funds or income funds can be great investments for college savings, avoiding the pitfalls of the stock market and potentially earning much more than is available in an FDIC-insured savings account. The Yahoo! Mutual Fund Screener can help you choose a fund that is right for you.