A good college fund often starts with large-cap stocks

ByABC News
January 26, 2012, 6:11 PM

— -- Now that little baby Bunky has arrived, several thoughts have crossed your sleep-deprived mind. Where are my keys? Why can't I follow the plot of Where's Spot? And shouldn't I be putting some money away for the tyke?

Starting an investment account for a child is a nice idea. You'll probably want a fund that will take small investments. And if you're looking for good long-term returns, make sure the fund invests in large or midsize companies.

First, we're talking about a future gift of money, not a college savings account. You should use a 529 plan for that, and those are a topic for a future column. (In the meantime, check out www.savingforcollege.com, which has excellent details on all the state 529 plans.)

Funding an account for the baby can be difficult because young parents often have the problem that financial professionals call "having no money." Mutual funds, which were designed for the small investor, would seem to be the ideal solution for them.

Many broker-sold funds have fairly low minimum investment requirements. But if you have very little money, you probably don't want to pay a brokerage commission, either.

Unfortunately, the minimum initial investment for most no-load funds, which are sold directly to you without commission, is fairly steep. Fidelity Contrafund, for example, requires $2,500 to open an account. The U.S. median family income (half are higher, half lower) is $49,445, so an investment in Contrafund would be about 5% of the average family's annual pretax income.

IRA minimums are usually lower than regular taxable accounts. Contrafund will let you open an IRA for $500, for example. But your child will need bona fide employment income to open an IRA, which is problematic for a baby. And, no, you can't hire Junior as a diaper consultant.

Your best bet is an automatic investment program. With an AIP, the fund taps your bank account at regular intervals and waives the minimum initial investment requirement. You have to keep contributing until you hit the fund's normal minimum.

What kind of fund? Assuming you plan this for 20 years or so in the future, a stock fund is probably the best idea.

Most advisers recommend small-company stock funds for young people, because they have plenty of time to make up for losses. Small-cap funds invest in companies whose market value is about $2 billion or less. And, while these stocks can produce terrific returns, small-cap funds have two drawbacks:

•Death. One reason small-cap funds are risky: Small companies are more prone to heading off to oblivion.

•Size. Ideally, you'd like to have bought Apple when it was a start-up and ridden it to its current position as the second-largest U.S. stock by market value. But Apple left the small-cap world long ago, if it ever was in it.

At the other end of the spectrum, large-company stocks tend to be less volatile than small-caps, and they're less prone (though not immune) to sudden demise. The big advantage to large-caps: dividends.

Over time, dividends are a significant addition to your total return. The Standard & Poor's 500-stock index has gained an average 3.59% a year the past 15 years. Throw in dividends and it's up a somewhat better 5.45% a year.