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Financial Answer Center

Developing a Funding Strategy

Understand Risk

There are several kinds of risk. The two that we will discuss here and that you 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 to those who need their money soon, not to 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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