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By Josh Peters, CFA | 10-19-2010 04:55 PM

Be Cautious Using Stocks to Save for College

Morningstar's Josh Peters says investors should be prudent in allocating equity for college savings, but dividend-payers are a good choice for those who can handle some market volatility.

Jeremy Glaser: What role should dividend stocks play in your college savings? I'm here today with Morningstar DividendInvestor editor Josh Peters to take a look at how stocks can be used to help you to fulfill your college savings goals.

Josh, thanks for joining me today.

Josh Peters: Hi, Jeremy. Good to be here.

Glaser: So college savings are a little bit different from, say, saving for retirement or saving for a lot of other goals because you really have a finite amount of time that you have to build the wealth and then you have to spend it in a really concentrated period over the three or four years that your child is in college. How do you think that people should think about using dividend stocks to help achieve that goal?

Peters: I think it makes a very interesting contrast between saving for retirement, which is, obviously, where the bulk of the money in the saving and the investing is going on. Where if you retire, let's say, at age 65 or thereabouts and you've got half a million or $1 million to work with, the idea is to never have to reach in and live off of that principal.

And if you don't ever have to sell your stocks at some point down the line when you don't know what they may be worth on a particular day or year, even that for that matter, and then use those funds to meet personal financial obligations, you're in a much better shape to just live off of the dividends, especially if they are growing.

In the case of college planning, and I think about this for myself, with two little kids of my own, I know I'm going to need a certain amount of money, may not know exactly how much, but it's going to have to be a big lump. I don't want to have to take the risk, that the market could drop 50% right in front of having to start writing checks for college.

This is the one case where you really can't get around trying to save a certain size pile as opposed to thinking about the flow of income.

Glaser: So you certainly would not want to be 100% in stocks right before your child is about to enter college?

Peters: I think the best way to think about it is that college planning has its own lifecycle. It's different than what you think in terms of retirement or other types of savings. If you have kids who are very little, then you have the opportunity to maybe look at some stocks.

Maybe it starts out being pretty high-weighted in stocks, but the closer they go, by the time they get five, maybe move a little more money in the longer term bonds at age 10 and look at bonds that mature in seven or eight years. By the time you get right close to the kill zone there where you get to start writing the checks, then it should probably be all in pretty short-term instruments.

That said, if you have the opportunity to start early, take advantage of the higher total returns that stocks can offer.

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