I occasionally get asked for my advice on the best way to save for college. I've typically referred them to more knowledgeable sources on these matters, since I don't have children and am currently trying to figure out the best way to pay back past colleges expenses as opposed to saving up for future ones.
Luckily, if you wait long enough, other people will do all the hard work for you. In this case, I’ll mooch off recent posts by Tim Ranzetta and Justin Fox.
With all the usual caveats about me not being a financial planner and this not being investment advice, here’s what I'd do if I were saving for college for someone.
First I’d open a 529 savings plan with Vanguard (No I’m not being paid by Vanguard - in fact, my retirement account is through them, so I'm actually paying them).
As for the money I’d put in it, there are two generalizations that will come in handy: 1) you’ll generally earn more on stocks than bonds 2) stocks are much more volatile – they can go down by a lot, as we’ve all just been reminded. This leads to a conflict: you want to have the highest returns possible, but you also don’t want to lose it all in a stock market crash on your kids’ 18th birthday.
The idea is to balance these competing desires by gradually shifting the account from stocks (or other investments) to bonds (fixed income in the quote below) based on the age of the child, and the riskiness of stocks.
The second of these is represented by the P/(avg 10E) terms below, and it is the price of stocks divided by their 10 year average earnings. When this number is below its historical average, stocks are priced relatively low (we think), and it is much less likely that stocks will crash, so you can keep money in stocks for longer. When this number is above its historical average, this indicates that stocks may be overvalued, meaning a stock market crash is more likely, meaning you should probably shift toward bonds more quickly.
Thus, my hypothetical plan is as follows:
When P/(avg 10)E is in lowest quartile, use fixed income at 100%, 75%, 50%, 25%, 0% for [age 16-17, age 14-15, age 12-13, age 10-11, age 9 and below respectively.]You can find the P/(avg 10)E data here (Excel file under “Stock market data”).
When P/(avg 10)E is in second quartile, use fixed income at 100%, 75%, 50%, 25%, 0% for [age 15-17, age 13-14, age 11-12, age 9-10, age 8 and below respectively.]
When P/(avg 10)E is in third quartile, use fixed income at 100%, 75%, 50%, 25%, 0% for [age 14-17, age 12-13, age 10-11, age 8-9, age 7 and below respectively.]
When P/(avg 10)E is in highest quartile, use fixed income at 100%, 75%, 50%, 25%, 0% for [age 13-17, age 11-12, age 9-10, age 7-8, age 6 and below respectively.]