People always say it’s never too early to start saving for college. That has never been truer.
Not only has student debt in the United States climbed to a record $1.4 trillion, but college prices continue to soar way faster than inflation and wage growth. From January 2006 to July 2016, the Consumer Price Index for college tuition and fees increased 63 percent, with consumer prices for college textbooks jumping 88 percent and housing at school (excluding board) rising 51 percent, according to the Bureau of Labor Statistics. Meanwhile, inflation has hovered mostly below 3 percent in the past decade while wage growth averaged only 6.29 percent growth from 1960 to 2017.
All of this means parents ought to start saving for college as early as possible, maybe even before their kids are born. The earlier they start, the more time their money has to grow and take advantage of the power of compounding.
Compounding happens when you reinvest your returns and those returns earn more returns and so on. Because investments can increase in value over time – and the longer the time, the greater the value – it’s important to start early to maximize the benefits of compounding.
For example, you begin investing $200 per month at the age of 25 in a tax-deferred retirement plan earning 9 percent, and your friend starts investing in the same plan at 45, but invests $400 per month. At age 65, you will both have invested a total of $96,000, but your investment would have grown to $884,000, while your friend’s investment would be worth only $268,000. This is because of your 20 extra years of compounding.
However, even with compounding interest on a savings account, savings accounts aren’t likely to keep pace fast enough with skyrocketing college costs. Instead, families should look to stocks for a better return. On average, the S&P 500 index returns 7 percent per year, adjusted for inflation, over the long-term. That compares to an annual percentage yield of 1 percent or less over the past decade for savings accounts.
The S&P 500 index is a basket of stocks aiming to reflect the overall return characteristics of the general stock market. Stocks in the S&P 500 index are chosen based on market capitalization, industry and liquidity.
But parents, already busy with work and kids, probably don’t have a lot of time to research and pick stocks for their educational savings portfolio. And even if they did, studies have shown it’s extremely difficult to choose a portfolio of stocks that consistently beats the S&P 500 index. Even if you hand your money to a professional money manager, most of them would also fail at this.
In the five years ending in 2015, 84 percent of large-cap funds generated a return less than the S&P 500. In the 10-year period ending in 2015, 82 percent of large-cap funds failed to beat the index. S&P Dow Jones’ 15th annual scorecard showed that over 15 years, 92 percent of large-cap, 95 percent of mid-cap and 93 percent of small-cap fund managers underperformed their benchmark.
Fortunately, there’s an easier way. It’s called low-cost index funds. An index fund is a mutual fund or exchange-traded fund (ETF) constructed to match or track a specific market index, such as the S&P 500 index. These are passively managed funds, as opposed to actively managed by a fund manager who buys and sell stocks based on research. Index fund costs, expressed as expense ratios, are much lower than in actively managed funds because they don’t require a research team or as many commission fees from moving into and out of stocks.
“When trillions of dollars are managed by Wall Street-ers charging high fees, it will usually be the managers who reap outsized profits, not the clients,” said Warren Buffett, legendary investor and Chairman of Berkshire Hathaway, in his most recent annual report to stockholders. “Both large and small investors should stick with low-cost index funds.”
Since there are so many types of market indexes out there, families don’t have to worry about diversity in their portfolio. If you believe technology outperform retail stocks, there are plenty of technology funds from which to choose and different ways you can allocate money to ensure broad diversification. You can even go more granular and choose a technology fund focused on a certain area within technology, e.g. software, Internet or semiconductors.
You also can set your account to reinvest any distributions automatically to take advantage of compounding and link your bank account to deposit money into the fund each month.
Investment possibilities are endless, and probably easier than you thought.
Guest Post written by Monica Taylor, Guest Author and soon to be blogger.