Source: The College Investor
529 plan investment strategies can be hard to navigate.
College and retirement savings plans often involve dynamic investment strategies, such as age-based and enrollment-date asset allocations for 529 college savings plans and target-date funds for retirement.
They start off with a high percentage invested in high-risk, high-return investments like stocks, and gradually shift the mix of investments to a lower-risk asset allocation as time passes.
In most cases, dynamic investment strategies use a linear glide path, where the percentage invested in stocks drops by a fixed amount each year. For example, a typical asset allocation for target-date funds bases the percentage invested in stocks on 100 minus the investor’s age.
As such, there is an immediate reduction in the percentage invested in stocks, but they move off of a high-risk mix of investments too soon.
A new patented dynamic investment strategy addresses this flaw by delaying the onset of the reduction in the percentage invested in stocks by a number of years. This can significantly improve your return on investment without significantly increasing the risk of investment loss.
Balancing Investment Risk and Return
The risk of investment losses is unavoidable when saving for college or for retirement.
Big drops in the stock market are called corrections and bear markets. A correction is a short-term decrease of 10% or more and a bear market is a more prolonged decrease of 20% or more.
Corrections and bear markets are largely unpredictable and therefore unavoidable.
During the 17 years from birth to college enrollment, the stock market will experience at least three corrections and at least one bear market.
During the 45 years from college graduation until retirement, the stock market will experience at least 10 corrections and at least four bear markets.
You can't expect to time the market to avoid corrections and bear markets. Instead, investors must adopt strategies that maximize the return on investment while reducing the negative impact of investment losses.
Related: 529 Plan Calculator
Dollar-Cost Averaging
One example of such a strategy is dollar-cost averaging. With dollar-cost averaging, one invests a fixed amount per month. When stock prices increase, this buys fewer shares. When stock prices drop, this buys more shares.
Rebalancing
Another example adjusts the asset allocation as the investments grow, rebalancing as needed to shift the investment portfolio into a lower-risk mix of investments. Over time, this reduces the percentage invested in stocks and increases the percentage invested in bonds, certificates of deposit, money market funds and cash, thereby locking in gains.
Investors can afford to take more risks in the beginning because less money is at risk and there is more time available to recover from investment losses.
As the goal approaches, shifting the portfolio to a lower-risk mix of investments will lock in gains and reduce the risk of investment losses.
Tax-Advantaged Accounts
Specialized savings accounts, like a 529 plan, 401(k), or IRA, allow earnings and appreciation to accumulate on a tax-deferred basis. Investors are able to sell investments within these college savings and retirement plans without having to pay capital gains taxes. As a result, investors are less likely to hesitate to rebalance their investment portfolios because of high unrealized capital gains.
Most of an investment portfolio’s long-term return on investment depends on the asset allocation, as opposed to the investment in specific stocks or bonds.
Delayed-Onset Investment Glide Paths
An investment glide path describes how the percentage of a portfolio invested in high-risk investments changes over time.
The glide paths for age-based and enrollment-date asset allocations for college savings and target-date funds for retirement start reducing the percentage invested in stocks too soon.
Instead, a delayed-onset investment glide path delays the start of the reduction in the percentage invested in stocks by a specified number of years. This can increase the overall return on investment without significantly increasing the long-term risk of investment losses.
The initial investment in stocks is sustained at a higher percentage for a longer period of time, and subsequent reductions in this percentage are compressed to fit the remaining investment time horizon.
Assuming a 17-year investment horizon, delaying the onset of a shift to a more conservative mix of investments by up to 10 years can increase the annualized return on investment by up to a full percentage point without significantly increasing the overall risk of investment loss.
The improvement in the annualized return on investment is about 0.1% percentage points for each year of delayed onset, up to a maximum of 10 years. So, a five-year delayed onset will increase the long-term annualized return on investment by half a percentage point. Delaying the onset by 11 or more years, however, leads to a big increase in investment risk and diminishing returns.
Assuming a 45-year investment horizon, delaying the onset of a shift to a more conservative mix of investments by up to 30 years increases the annualized return on investment by up to 1.4 percentage points without significantly increasing the overall risk of investment loss. The investment risk starts increasing significantly after a delayed onset of more than 30 years.
What does this actually mean? The best 529 plan investment strategy doesn't shift rapidly to conservative investments , but rather tries to go at least 10 years at an aggressive investment before shifting to more conservative investments.
For More Information
These results are based on U.S. Patent 11,288,747, Method, System, and Computer Program Product for Developing, Evaluating, and Validating Investment Glide Paths.
Mark Kantrowitz is an expert on student financial aid, scholarships, 529 plans, and student loans. He has been quoted in more than 10,000 newspaper and magazine articles about college admissions and financial aid. Mark has written for the New York Times, Wall Street Journal, Washington Post, Reuters, USA Today, MarketWatch, Money Magazine, Forbes, Newsweek, and Time. You can find his work on Student Aid Policy here.
Mark is the author of five bestselling books about scholarships and financial aid and holds seven patents. Mark serves on the editorial board of the Journal of Student Financial Aid, the editorial advisory board of Bottom Line/Personal, and is a member of the board of trustees of the Center for Excellence in Education. He previously served as a member of the board of directors of the National Scholarship Providers Association. Mark has two Bachelor’s degrees in mathematics and philosophy from the Massachusetts Institute of Technology (MIT) and a Master’s degree in computer science from Carnegie Mellon University (CMU).
Editor: Colin Graves Reviewed by: Robert Farrington