By Dr. James M. Dahle, WCI Founder
One of the dogmas of financial planning is that the shorter the time period between now and when you need the money, the less risk you can afford to take. While it is true that as the years go by, your retirement asset allocation ought to become less risky, that doesn't necessarily apply to all your other savings goals.
Most people fail to consider three other factors.
- The consequences of not reaching your goal.
- The money may be needed over a range of time rather than all at once.
- Your risk tolerance is higher when you're investing someone else's money.
Consequences Differ Greatly by Savings Goal
Consider someone saving up a downpayment for a house. She may want to buy it in 3 years, so the traditional advice is to not take much risk with the money. But what are the consequences of not having exactly the amount she needs in 3 years? She's got a couple of other options.
- She could buy a less expensive house.
- She could continue to rent for a few more months or even a couple more years while he saves some more money.
Not that big of a deal. Much different than not having enough money to retire.
The Longer the Withdrawal Period, the More Risky Assets You Can Have
The other factor rarely considered is whether a lump sum is needed or a stream of income. A downpayment on a house, for instance, is needed all at once. Retirement, on the other hand, is funded over a period of decades. That's why you don't have a 100% cash portfolio by age 64.
It's Easier to Take Risk with Someone Else's Money
Financial advisors find it much easier to tolerate market ups and downs than their clients do. They spend a great deal of time in volatile markets “holding their clients' hands” so they don't panic and sell out. Psychologically, it's hard to watch money you were counting on to provide you security disappear. But sometimes in personal finance, you're not actually investing for yourself.
Consider an older investor with a large nest egg. He realizes that he is investing much of his portfolio for his heirs or a charity. At that point, he may start investing that money much more aggressively than the money that is providing the income stream he is living off of. He might rationally have a riskier asset allocation at 85 than he had at 65.
Should I Take More Risk with a 529?
My kids' 529 accounts are invested 100% in stocks despite the fact that my kids will matriculate in only 2-13 years and the fact that my retirement portfolio is only 60% stocks. The accounts aren't that large yet, so there is definitely a need for the money to grow. But more importantly, those 529 accounts meet all 3 of the above criteria.
Consequences of a Small 529 Account
Guess how big my 529 account was when I started college 18 years ago? That's right, zippo. I seemed to get through both college and medical school, pretty much without loans too. There are lots of options they can take if the 529 doesn't cover all the costs:
- Go to a less expensive school
- Get scholarships
- Work full-time in the summers
- Work part-time during the year
- Join the military or other organizations who will pay for school
- Have a lower lifestyle in college (no car for instance)
- They can take out loans
- You can take out loans
- Use your current earnings
Those consequences seem pretty minimal compared to eating Alpo during retirement. Therefore you can take more risk.
529 Money Isn't Needed All at Once
My oldest is 16, so I'll need to start using that money in just 2 more years. But I don't need it all on September 1st, 2022. She'll likely go to college for 4, or even 5 years. She may take a year or even more off. She may go to grad school or even medical school. It's possible she'll be withdrawing over an entire decade. So some of that money might not be needed for 9 years or more. That allows the portfolio to recover from a down market that may occur just before she matriculates.
It's Really Not My Money
Psychologically speaking, this is money I've already spent on my kids. I've mentally divorced it from the rest of my portfolio. Since I don't have to deal so much with the consequences of it performing poorly, it is far easier for me to tolerate its volatility. I hardly even look at it. That allows me to invest it aggressively without feeling a need to bail out in a down market.
There you go, three reasons to consider having a more aggressive asset allocation in your 529s than in your retirement portfolio. Agree? Disagree? Comment below!
i cant agree with you on this one. I think a limitation of 529s is the time period. Its a limitation that people should just recognize and plan accordingly. If you are too aggressive then you can have near nothing when you need it. I think people just need to plan appropriately meaning they will need to save more. It also is your money. If you are a physician then likely you are paying in part for your kids education. If the investments do poor, you are likely paying more later. I dont see how this becomes some one else’s money. I personally cant do a jedi mind trick on myself.
For retirement, you can work a few more years if necessary. It likely isnt wise to delay going to college a few years.
Several of the other points are true but i still dont see them as reasons to be overly aggressive. There are however consequences for some of those things. For instance not everyone is going to work full time and receive the same grades in college. I am a fan of the ROTC and HPSP routes as you know although we differ a little on their benefits and negatives.
white coat investor and Rex,
I would like to hear your asset allocation strategy for your 529 plan ?
If you are 100% stocks for a 7 yr old…..what is your planned asset allocation as your child gets older ?.
My child is 4 years old currently. My asset allocation is currently ( 70% Total US Market Index, 20% Total International INdex, 10% Total Bond Index).
My plan for age 6-12( 60% US , 15% International, 25% Bond), age 12-18( 40% US, 10% International, 50% Bond). Depending on the value of the portfolio and my childs college plans/costs around age 16-18……I may move a percentage of the portfolio to a stable value fund.
im not a good person to ask for that particular question bc mine is with utah and its an age based primarily vanguard approach. i believe they allow you more control if desired.
Good discussion. I am going with more conservative approach. I am in Virginia and planning to buy prepaid for my both kids. I think it gives me a good security. In Virginia it includes top rated universities like University of Virginia and Williams & Mary. And then if I can save more later, I can start putting in regular 529 which can be used for housing etc. I see it as an insurance for my kids education. It might not cover Hopkins or Duke, but UVA is right up there
Sam did you end up using the Va prepaid plan? Have you been happy with it?
My wife and I are trying to compare the prepaid vs Invest. We both went to VT and recently moved back to Va. Children are 7 and 5. With the increasing cost of college It seems like a great deal and fortunately Va has many great schools. Prepaid isn’t cheap!!
I Would appreciate any recommendations. We’ve considered potentially prepaying for 2-3 years for each kid then putting the rest in Invest.
Thanks in advance,
Bailey
I am 100% stocks for all my kids (7,5,2) and it is split 50/50 between Total (US) stock market and total international stock market.
When will I get less aggressive? Haven’t decided yet. Certainly not before they’re 15. I just feel like I can really take a lot of risk with this money since it isn’t my money nor do I have to bear the consequences for its loss. I don’t feel responsible to pay for my kid’s schooling. If they decide to go to Yale and there’s only $40K in the 529, that’s their problem. Will I help out of current earnings? Probably, at least some. Will I take a loan out for their college? No way.
There’s nothing wrong with an age-based allocation for a 529, just like I think it’s a fine choice for a retirement plan in many cases. Certainly if I were going to recommend an asset allocation to a family member, I’d probably recommend an automatic age-based option.
I really don’t understand this logic. You wouldn’t gamble your retirement accounts with a 100% stock allocation. Then why would you be willing to gamble with your kids education? In my opinion the approach should be exactly the same retirement vs college savings. The time frame is just different and allocation should be adjusted accordingly. My goal is different as I would like to be able pay for all my kids education. But I completely agree that in no way should that interfere with retirement savings. My oldest is only 4 and fortunately I was able to max out contributions to a 529 during the bottom of the market in 09. I am already considering moving some of the funds out of stocks given the significant gains. My goal is to be able to cover the costs of college with 529 plans and graduate school can be paid for with non-retirement accounts. After age 23 the kiddie tax will no longer apply so gifts of stocks (28k today’s dollars) would most likely not be subject to long term capital gains when my kids are in graduate school.
I think the reason you’re not getting the logic (which I think it is pretty well explained, but if not, here’s a more recent post on my thoughts on my children’s educations: https://www.whitecoatinvestor.com/how-my-children-will-pay-for-their-college/) is that you’re planning to pay for all of your children’s education. I’m not. Since I’m not planning to pay for all of their education (like a defined benefit plan) but rather am making defined contributions towards it, I want to take the approach that is most likely to give them to the most amount of money toward their education. The approach most likely to provide the most money is an aggressive asset allocation.
Other reasons I can be aggressive include that it is currently a relatively small amount of money in their education funds and that the consequences of shortfall are so minor compared to a retirement shortfall.
Sam,
I am familiar with all the schools you mentioned to varying degrees. I do think those are excellent state schools–two good reasons to live in Virginia. With regard to pre-paid plans, you should at least read up on the experiences of other states. Virginia’s VPEP plan has a statutory guarantee not a constitutional guarantee and could be changed by the General Assembly, although subject to veto, if they have a budget shortfall (states this clearly on the VPEP main page). I would also consider what you would do if your children did not get into UVA or William and Mary. Would you be okay with Virginia Tech, VCU, Old Dominion, James Madison, etc. if they could get into better out of state schools? Probably would depend in part on their planned course of study.
A possibility to consider would be to hedge your bets, similar to the tax diversification concept. For instance, you could potentially purchase one or two years through VPEP and fund the rest with a combination of the VEST plan and cash flow during their college years. That said, I don’t think there is a clear best way to go. You can only plan so much. Good luck.
Interesting post.
Another point that isn’t mentioned that allows you take some risk is you can change the beneficiary, like another child. For example, I have 3 siblings and my youngest brother is 9 years younger. My parents had children in college continuously since 2001 and my brother will graduate in 2013. That’s a 12 year span to use the 529 (oh yeah, that reminds me I owe them thank you #178 for their support) and now there’s a grandchild.
Great point. Wish I’d thought of that.
I’m new to the WCI and catching up on the classic WCI posts. I’m in my second year post fellowship. Something you touched on here, is saving for retirement vs a house. I have a financial advisor. Per his advice, I spent my first year saving 6 months of post-tax salary for emergency funds, at the same time putting 10% income in a 403B and $5500 in a roth IRA. Now saving as much as I can towards a house, which I’d like to buy in 1 year. Am I doing myself a disservice by not putting away 20% towards retirement (as you recommended elsewhere) and delaying buying a house?
No. If you’re doing any disservice at all it is simply that you’re not putting 20% toward retirement, saving up that emergency fund, and saving up a house down payment by living like a resident. But if you’re simply not willing to live that cheaply, then you’ll have to prioritize because you then can’t do them all at once. But they’re all good things to do and the order doesn’t matter much.
If you don’t mind saying, how much are you spending in comparison to what you spent as a fellow? 1X, 2X, 3X? That’s where I’d focus for your first 2-5 years out of training. Try to make the percentage of your income going toward wealth building as high as possible and worrying less about where exactly it is going. As you can see, you’ll have it all done very soon (emergency fund, blossoming retirement funds, house down payment, student loans paid off etc.)
Really appreciate your reply. I’m spending 1-2x more. Trying to live like a resident. Increases in spending have to do with kids (day care tuition, more groceries, activities, etc). Thanks so much for your advice.
Not too bad. Like I said, you’re going to get where you want to be pretty soon. If you are comfortable with it, you might cut your E-fund to 3 months and use the extra toward your other goals too.
Hi Josh,
Keep reading the blog it will really help guide you. There are so many variables to consider. One you need a place to live. I assume you are renting, how long do you plan on staying in your house and what is the difference between rent versus buy in your location. In general the longer you plan to stay in a home the better it is too buy. That being said some who bought in 2007 and just finally coming above water. I would also recommend reading more about financial advisors on the site. He does a great job breaking down the pro’s and cons of advisors. I like to think of advisors in three groups. 1) salesman who also give advice while trying to sell whole life. 2) fee based. They manage your portfolio for a fee. 3)paid by the hour to give advice. In my opinion the first one should be avoided like the plague. The second one is preference, since you are in this site you can easily learn what you need to save yourself 1-1.5% fee.
Good luck!
Don’t mistake fee-based for fee-only. Fee-based means they get a fee and a commission.
I tried to keep it simple. I would tend toward lumping those that also charge commission or sell a client loaded funds on top of their fee to manage a portfolio to be more of group #1 and should be avoided. Basically anyone who makes money by selling you a product does not have your true interest at heart, in my opinion.
Thanks, Lee. Fair enough. I was told by so many people to get a financial advisor because I have no idea what I’m doing. As I learn more, will likely reassess soon.
I know this is an older post, but I imagine it continues to attract new WCI readers, so I wanted to offer an alternative perspective. My wife and I both had to pay our own way through college. For me that meant scholarships, but for her it meant 6 years of working and taking classes. As a result we both agreed it would be a priority to pay for a four year education for both kids. My mindset was that I needed to be absolutely conservative with the money to guarantee it would be there when freshman year arrived. We actually did two things. We bought a rental house with positive cash flow with the intention of refinancing for one of the college educations. (The real estate story is another whole post –originally five, but we kept two with positive cash flow.) Then we started with EE savings bonds for lack of other options. Our income outpaced the savings bond tax break, but around then 529s became an option. The hard part was finding a plan that had low cost funds invested in ST bonds (NYSAVES and Vanguard). Just to clarify, I knew that theoretically I was giving up greater potential returns by staying away from stocks. And I was definitely giving up an immediate tax break by using an out of state 529. But remember, my overriding concern was to ensure the money would be there. And I knew there was zero reason to believe I would correctly time the stock market. I felt somewhat vindicated when my daughter started college in 2008 and the stock market dropped 50%. Plenty of money in both 529 accounts to pay for two full time educations. We never touched the rentals. By the way, it does require prioritizing, but along the way we managed to also fully fund retirement, so both are possible.
Three bones to pick with your approach:
# 1 In the worst case scenario, which you experienced, you managed to avoid a 50% drop. But by investing conservatively for 18 years before, you probably missed a 100% gain. Maybe if you had invested more aggressively, your portfolio would have dropped to the value it grew to using a conservative strategy.
# 2 To make matters worse, 2008 had a fast recovery. By your daughter’s senior year in 2011, not only did that money recover to its original value, but it was ahead.
# 3 You don’t mention your state, but if your state did offer a tax break for the 529, in many states you could have just rolled it over to another state without having that tax break be recaptured. And if not, the tax break was likely worth several years worth of conservative returns. In my state, I get a 5% tax credit. If ST bonds are paying 1.5%, that’s 3 years worth of extra returns right there. Definitely worth paying a little higher ER or whatever to get that.
At any rate, there are many roads to Dublin. You had a goal, and you used a method that reached that goal. That’s success. You might have had to save more than you otherwise would have, but given the timing, probably not by much. So, well done!
I like your back up plan with the real estate too, and have written a bit about it here: https://www.whitecoatinvestor.com/real-estate-as-a-college-savings-tool/
If I wasn’t clear, let me stipulate that I completely accept your argument from a rational perspective. I always knew my plan was more driven by emotion than logic. We really wanted the money to be there for college, and we did not want to take any risk. So, I offered my story in case any others out there felt the same way.
As an aside, we kept all of our money earmarked for retirement 100% in equities until recently when I started to reposition to a more balanced portfolio. The overall (mix (college plus retirement plus savings for near term wants) was aggressive by any reasonable measure. We just earmarked the safe money for college. Anyway, I don’t necessarily recommend my approach; but just want your readers to know it can work.
But the best part about your story is that it wasn’t an irrational “I’m scared so I’m going to invest in ST bonds for college” kind of thing. It was a “I’m going to invest in a low expected return investment so I’ll need to save more and I can do that” kind of thing. That’s why you were successful.
Interesting that you feel just the opposite that I do- I feel I can take more risk with 529s than retirement and you felt the opposite.
Since it is all behind me I can say with hindsight that your approach, towards both 529s and the kids paying a share, would have worked great for me too. I guess it is just a personal answer on where to accept risk.
One factor not discussed above is that I have a military pension, so I can afford more risk with my retirement investments. In the worst case I would work longer, which I might anyway. But the college was on a schedule.