Lifecycle Investing by Ian Ayres

Author:Ian Ayres
Language: eng
Format: epub
Publisher: Basic Books
Published: 2010-04-11T16:00:00+00:00

Saving for College (and a Rainy Day)

Most of us have lots of different cookie jars for savings. One jar is for retirement, another for the kids’ college, another for an emergency. Even if the jars aren’t real, we keep mental accounts of how our savings is to be allocated across different pots. This begs the question of whether it’s okay to commingle the different funds and, if so, how you should do it.

To answer that question, let’s say that you are forty with $90,000 already saved for retirement and $50,000 saved for your kids’ college tuition, and the value of your future savings contributions adds another $310,000. Thus your total savings are $450,000. How much of that $450,000 should you invest in equities?

The first part of the answer depends on your strategy. Say, you choose to follow a 200/50 path, so you’d like to put half of your total retirement savings into equities. But your total retirement savings isn’t $450,000 because $50,000 of that amount is earmarked for tuition. Therefore, you should apply the 50 percent Samuelson share to $400,000, for a goal of $200,000. Of course, you don’t have $200,000 available today, so you’ll need to use some leverage.

Now the question is whether you should leverage the $90,000 earmarked for retirement at 200 percent leverage or take the full $140,000 and leverage that amount at just 143 percent to hit your $200,000 goal. Here, commingling is a good idea. It lets you get to your $200,000 goal that you otherwise wouldn’t quite make investing only the $90,000. What that means in practice is that you might borrow $60,000 on margin or invest $60,000 at 2:1 leverage and invest the other $80,000 without leverage.6

What you’ve really done is “borrow” the $50,000 earmarked for college and put it to use temporarily in equities. The fact that you have this cash available today allows you to take a bit more market exposure: You can get all the way to $200,000 rather than limiting yourself to $180,000. And using the $50,000 in savings reduces your need for outside borrowing. You are borrowing from yourself before going elsewhere.

But what if a $20,000 tuition bill arrives, and you have all your liquid assets invested in stocks? At this point you have to come up with the money. One option is to take out a loan. The Federal PLUS loan program (for parents with good credit) offers loans at 8.5 percent, minus 0.25 percent if you enroll in automatic debit.7 While that is better than most credit cards, it is still too high to justify borrowing in order to buy stocks with leverage. Not taking the loan is like getting an 8.25 percent risk-free, tax-free return on your money. That’s a better deal than investing in stocks. So don’t take out the loan if you have any other assets available.

In our example, you had $140,000 available that was invested at 143 percent leverage. The solution to your liquidity needs is to take $20,000 out of the equity, leaving $120,000.

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