Planning for College | Redstone Federal Credit Union

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Understanding Risk

In setting your objective, make sure you take into account your risk profile. That is, how much risk are you willing to take? Think of investment and risk as running across a spectrum, where investments with low risk are at one end and high risk at the other. With lower risk investments, safety of principal and minimal or no fluctuation in the value of your account is critical. As a trade-off, you are willing to accept a lower rate of return. Your tolerance for risk is usually lower when your time horizon is short-term. Typical low-risk savings vehicles include passbook savings accounts, certificates of deposit, and Series EE and Series I Bonds.

With higher risk tolerance, your goal is growth in your portfolio. You are seeking higher returns. You are willing to accept greater volatility over the short-term because your time horizon is long-term. Typical investments are growth stocks, international stocks and real estate.

There are several kinds of risk. Two types that you will need to consider are market risk and inflation risk.

Market Risk

Cash-type accounts (bank accounts) are designed to provide safety of principal. You put a dollar in—you get a dollar back with some interest. The value of your account increases because your principal earns interest and your interest earns interest.

Bonds, or notes (less than ten years to maturity), are designed to pay you a fixed rate of interest over the life of the bond. They typically pay a higher return than cash accounts. When the bond comes due (matures), you get your principal back in full (assuming it doesn't default). Prior to maturity, the value of the bond can go up or down depending primarily on the direction of interest rates.

Common stocks offer the potential for even a higher rate of return; but the value of your investment is subject to even greater volatility over the short-term. The stock's volatility is subject to market conditions and the financial well-being of the company you've invested in.

To sum up, market risk is the measure of how much the value of your investment can vary.
History shows us that investing in common stocks means that risk in the short term is greater than the risk in the long term. It suggests that those who need their money soon should not invest in stocks.

Inflation Risk

The higher the inflation rate, the higher the cost of college will be when your child attends. If you do not put your money in investments that stay ahead of inflation, your college investment strategy will not be effective because your investments will actually lose value over time.

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