Two new age-based investment strategies can improve the return on investment for 529 college savings plans without significantly increasing the investment risk. In some cases the investment strategy may even reduce investment risk.
Investment risk is largely unavoidable, if one has long enough of an investment horizon. For example, the stock market will drop by at least 10% at least three times during any 17-year period from birth to college enrollment. At least one of those stock market "corrections" will involve a drop of 20% or more, known as a bear market.
Age-based asset allocation
College savings plans offer age-based asset allocations as a way of managing this risk. When the child is young, an age-based asset allocation starts with an aggressive mix of investments, which offers a greater return on investment, but also a greater risk of loss. Less money is invested, so potential losses are limited, and there is also more time available to recover from losses. As the investment grows and more money is at risk, an age-based asset allocation gradually shifts to a more conservative mix of investments. As the child approaches college age, most of the portfolio is invested in asset classes with a low risk of loss.
A typical age-based asset allocation starts off with 80% of the portfolio invested in stocks, periodically reducing this percentage until only 20% of the portfolio is invested in stocks.
But, traditional age-based asset allocation strategies for college savings shift to a conservative mix of investments too quickly. A better approach involves sustaining an aggressive mix of investments for several years before transitioning to an age-based asset allocation. The age-based asset allocation is compressed to fit the remaining investment horizon. Since the portfolio is maintained in a higher risk profile only during the first few years of the investment glide path, the increase in overall risk is minimal and may be offset by the higher return on investment.
Delaying the onset of age-based investment
Delaying the onset of an age-based asset allocation by up to 10 years can increase the annual return on investment by as much as one percentage point, without significantly increasing the investment risk. Each year of delayed onset increases the annualized return on investment by about 0.1 percentage points (10 basis points). These investment strategies were evaluated using all 204-month (17-year) periods from 1950 to 2017. Although past performance is not necessarily predictive of future results, this analysis can provide insights into the typical range of investment performance.
Delaying the onset of an age-based asset allocation by up to 10 years improves overall investment returns without significantly increasing the investment risk. The investment risk grows significantly if the onset of the age-based asset allocation is delayed by 11 or more years.
The improvement in performance is the equivalent of as much as a percentage point increase in the annualize return on investment. This could yield as much as an 8% increase in total college savings over a 17-year investment horizon.
Increasing investment risk during the early years
Increasing the initial percentage of the portfolio that is invested in high-risk investments from 75% or 80% to 100% can also improve investment returns without much of an impact on risk. Again, this is because the more aggressive mix of investments is maintained only during the first few years of the investment glide path, when less money is at risk of loss.
These charts show a linear glide path that shifts from 80% stocks to 20% in increments of 3.75% percentage points and a linear glide path that shifts from 100% stocks to 20% in increments of 5.0% percentage points.