It’s back to school time, which means a lot of parents are either once again footing the bill for their children’s college expenses or are wondering how they’re going to save for the time when that day comes. I want to talk to those parents in the latter group who don’t have a solid plan in place yet.
The Economics of Paying for College
According to The College Board’s latest study, attending college in 2015–2016 comes at an average cost of $19,548 at in-state public schools. If your kids want to attend a public school in another state, add another $14,483. That might seem like a lot, but private schools still reign supreme cost-wise, with tuition and fees averaging $43,921.
Of course, these are averages. Some schools will cost more, some will cost less. Plus, these numbers don’t factor in cost of supplies and books (which can be another big chunk of change) or the potential benefit of scholarships and other financial aid. Actual costs vary quite a bit depending on several factors including the location, institution, and course of study.
Exhibit 1: The Cost of College
Source: The College Board, “Trends in College Pricing 2015.”
And of course it’s never quite that simple. To make matters more complicated, the amount of goods and services $1 can purchase now will likely differ considerably from how much it will buy when it’s your turn to pay up. For that, we have our old friend inflation to thank.
One way we measure inflation is the Consumer Price Index (CPI), which looks at changes in the price level of a basket of goods and services purchased by households. Among the sundry goods in the CPI basket are your usual college costs—tuition, fees, books, food, and rent.
Over the past fifty years, the CPI says inflation in the US has averaged 4.1% per year. At that level, the purchasing power of $1 will drop by about 50% over eighteen years. At 3%, purchasing power of $1 would dip roughly 40%. At 5%, it would decline by around 60%.
We don’t know what inflation will look like next year or eighteen years from now, but history shows us that the amount of goods and services $1 can purchase can be expected to decline over time. We also can’t predict what the cost of attending college will be, but it’s a pretty safe bet that’ll go up.
So what can you do to prepare for the costs of a college education? How can you work toward affording to put your children in the school they want?
Literally Investing In Your Children’s Future
Simply put, you can invest in assets that are expected to grow faster than inflation. By doing this, you could ultimately pay for college with fewer dollars saved.
Of course these higher rates of return come at the risk of capital loss, so you want to make sure you have a robust risk management framework in place. And if you use a tax-deferred savings vehicle (like a 529 plan), you might not even pay taxes on your savings growth, which also helps lower the cost of funding future college expenses.
Over the past fifty years, stocks (as measured by the S&P 500) have returned over 9% annually. Remember, during that same stretch of time, inflation clocked in at an average of 4% per year. So the “real” (inflation-adjusted) growth rate for stocks has been around 5% per year. So that means $10,000 of purchasing power invested at this rate for eighteen years would become around $24,000 of purchasing power later on.
The real rate of return on stocks can be expected to increase the purchasing power of your savings over time. We can also expect that the longer the horizon, the greater the expected growth. In other words, the earlier you invest in stocks, the less you should expect to actually have to save.
But that’s not a guarantee. Investing comes with risks. Like freshmen in college, investing can be unpredictable, full of surprises, and, if you’re not careful, expensive. The markets have been reasonably calm most of this year, so it might be hard to remember this at the moment, but volatility is a normal part of investing. Tuning out short-term noise is hard, even for the most disciplined investors, but historically, investors who have maintained a disciplined approach over time have been rewarded for doing so.
Risk Management & Diversification: Your Investing Roommates
So what about that risk management framework we mentioned earlier? As always, we suggest teaming up with an advisor you trust who uses a transparent approach based on sound investment principles. Pairing a financial professional with a disciplined investing approach can limit unpleasant (and often costly) surprises and ultimately contribute to better investment outcomes.
Discipline is key, but it doesn’t come out of nowhere. A key part of maintaining discipline is having a well-defined goal (like paying for college) in mind from the beginning. Then we can pick investment instruments that can reduce uncertainty with respect to that goal.
When saving for college, risk management assets like bonds can help stabilize the likelihood of your portfolio being large enough to cover college expenses in time for enrollment. Investments like these can help you tune out short‑term noise and keep your eye on the finish line. As your kids get closer to college age, the right balance of assets should probably shift from assets with higher expected return to these assets geared more toward risk management.
No risk management strategy—especially one geared toward education planning—is complete without diversification. As Nobel laureate Merton Miller used to say, “Diversification is your buddy.” A long-term approach and diversified portfolio are essential for risk management.
A diversified portfolio can help reduce the negative impact of any one company or market segment on your wealth. That, plus it helps take the guesswork out of investing.
Active managers think they can consistently guess which investments will perform best every year and, well, they can’t. That’s a guessing game, which is not something we recommend when saving for your children’s college. We believe that by holding a broadly diversified portfolio, you are better positioned to capture returns wherever they occur.
The cost of higher education is rising higher and higher, so it makes sense to plan well in advance. Education planning comes with a lot of unknowns, and there is no blanket approach that works for everyone. But a disciplined approach to saving and investing can remove some of the uncertainty for parents.
Want to see how we can help you prepare for your children’s college expenses? Set up a meeting with one of our advisors today.
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