From: kenr@orleans.storage.tandem.com (Ken Rose)
Subject: Re: $200/month for 18 years investment
Reply-To: kenr@orleans.storage.tandem.com
Organization: Tandem Computers Inc.
Date: Fri, 8 Jan 1993 23:49:30 GMT

In article 28979@news.eng.convex.com, dodson@convex.COM (Dave Dodson) writes:
>In article <4245@ncrsoph.Sophia.NCR.COM> sstasuke@ncrsoph.Sophia.NCR.COM (Steve Stasukewicz) writes:
>>
>>I have a 3-month old son, and am starting to save now for his education.
>>I have budgeted $200 month to "put away" for him until he is 18 years old.
>>( Or whenever he graduates from college.  If he takes after his mother's
>>side, it may be later.  I hope she doesn't read this.  :)  Anyway, where
>>should I invest this $$$ to maximize my earnings?   
>
>Before you choose what investments to make, you should figure out what you
>goal is and what kinds of investments will allow you to meet your goal.

                                 [deleted]

>So suppose you choose 4 years at $26K/year = $104K to accumulate in 21 years.
>If you have a spreadsheet program, you can use the IRR function to determine
>the internal rate of return you have to make on your $200/month for 21 years
>= 252 months in order to be able to draw out $2167/month for 48 months.
>Computing the IRR is the key, because it determines how much risk you must
>take to achieve your goal.  Being too conservative will leave your student
>short of cash.  Trying for a higher rate of return than needed exposes you to 
>unnecessary risk.  It looks like achieving 7% would be adequate.  Hence, I
>suggest using investments that pay about 7-8%, which would be bonds,
>certificates of deposit, etc.

The bond approach might actually be a risky one.  If inflation stays low, then
the bonds will provide enough real return to do exactly what Dave said.

However, recall that bond prices are inversely correlated with interest rates;
if interest rates go up, then bond prices (and the yield of long-term bond
funds) fall.  So if inflation should jump to 10 or 12% a year, the value of
long term bonds and mutual funds invested in those bonds will nosedive.

Even buying an actual bond and holding it to maturity in 18 years, to attempt
to sidestep the drop in bond prices if interest rates rise (since you will get all
your principal back at maturity) does not work.  For example, a zero coupon
bond returning 7% a year with an 18 year maturity will sell for $295.86 today.
If, the day after you bought it interest rates rise to 12% the bond will fall
in price to $130.04.  But, one might argue, I don`t "lose" any money if I hold
the bond to maturity since I`ll get my $1000 back.  True, but the $1000 has
been eroded in purchasing value and won't buy as much after the extra 5% inflation.

In sum, buying bonds from a solid issuer lets one rest easy in the knowledge that
ones *nominal* principal will be returned; however the *actual* purchasing power
returned will be less than expected if inflation resumes at a higher-than-anticipated
rate in the interim.

____________________________________________________________________
Ken Rose    (kenr@storage.tandem.com)
The Usual Disclaimer:  Any opinions expressed above are mine alone, not
those of my employer (who is kind enough to allow me Usenet access).