Soaring college costs often force you to think like a portfolio manager. Should you load up your higher-education kitty with more stocks than bonds? What about the risk it takes to achieve your goal when you do so?
Then there's the vexing fundamental question of keeping up with the rising cost of college, which is often three times the rate of consumer inflation. Fortunately, there are some benchmarks that will help you.
You need your portfolio to provide "a long-term return that is at least as much as the college inflation rate," says Burton Baker, of 1693 Analytics LLC in Williamsburg, Va. "This strategy makes the most sense for those looking to fund a college education through a lump-sum strategy and helps answer the questions 'How much do I need to invest now, and how much risk do I need to take on?' "
Based on college-fee increases from 1990 through 2007, he has calculated return targets that investors should try to match or beat. He's including tuition and room and board in total expenses in this average. For state colleges, the average annual rate of increase over the past 17 years is 6 percent. It's 5.21 percent for the largest private schools. How much you pay, of course, depends upon the school. Private colleges have had a lower rate of increase in tuition, but can cost more than $40,000 per year.
Virginia ranks lowest in Burton's average expenses, at 4.6 percent. At the other end is Hawaii, boosting fees at a 7.3 percent rate. Just to keep pace with college expenses in the island state, you would need to earn at least 7.3 percent. And that's after you subtract all commissions and management fees.
How do you keep up with climbing college costs? Unless you are running your own portfolio, the best way is through a low-cost, commission-free 529 savings plan. Most programs provide an age-based feature that will automatically allocate money within the plan to mutual funds investing in stocks or bonds. The older the child, the more bonds the manager will add, and stock-market risk falls.
If you choose to invest in stock funds on your own within a 529, you need to be much more selective.
How much stock-market risk you take is guided by how much a state has been raising college fees. Let's say you have your eye on New Jersey state colleges, where Burton has found that fees have risen 6.4 percent. That's higher than the national average, but not as much as Alaska and Hawaii, with rates of more than 7 percent.
Burton estimates you'll need at least 40 percent of your portfolio in stocks to keep pace with New Jersey's rate of increase. In Massachusetts, you can take less market risk, since it is slightly below average at 5.57 percent.
Boiled down, the more college fees have risen, the higher percentage of stocks you will need -higher risk that is unavoidable if your goal is to at least match college inflation.
John F. Wasik is a Bloomberg News columnist. He can be reached at email@example.com.