Efficient Portfolios for Saving for College

Posted: 20 Mar 1998

See all articles by Sherman D. Hanna

Sherman D. Hanna

Ohio State University (OSU)

Peng Chen

Ibbotson Associates

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Abstract

This article uses 69 years of real rates of return for six types of financial assets to find efficient portfolios for saving for college, in terms of mean and minimum accumulations. Small stocks are in every efficient portfolio. For 10 and 15 year time frames, the portfolio that was the safest consisted of 89% intermediate term government bonds and 11% small stocks. A family willing to stay 100% invested in small stock mutual funds until each year's college costs must be met can greatly reduce the burden of saving for college, at relatively low risk.

In saving for college, the allocation of asset categories in the portfolio is a crucial decision. Most people are not willing to take above average risks to obtain above average returns on their investments (Avery & Elliehausen, 1986). Saving for college is a difficult investment challenge, as few families can afford to invest large lump sums early, so the most common investment plan consists of periodic investments over a relatively short time period. In considering risk versus return, various approaches have been taken, including a focus on the possibility of a shortfall in consumption or in some arbitrary goal (e.g., Leibowitz & Langetieg, 1989; Leibowitz & Kogelman, 1991; Ho, Milevsky & Robinson, 1994). For college saving, consideration of a shortfall is complex, and must be placed in the context of a comprehensive financial plan. The unique contributions of this article are the discussion of saving for college in the context of a comprehensive financial plan, the use of real rates of return, and the calculation of efficient portfolios for college saving.

Saving for college is often presented as merely a mathematical exercise, using future value tables and estimates of future college costs to generate the required periodic contribution to a college fund (e.g., Leonetti & Feldman, 1995). Ideally, though, saving for college should be considered in the context of a comprehensive financial plan. All of the areas of financial planning may be relevant to saving for a college fund. The usual advice -- to start contributing to a college fund as soon as a child is born ~ should be modified if a family does not have adequate insurance coverage or has outstanding balances on credit cards.

The family's values and goals, and short term needs, such as finding quality child care for a young child, need to be considered along with a goal of starting a college fund early. Tax planning is a very important for deciding whose name should be listed for a college fund. For some wealthy parents or grandparents, estate planning may be important in considering a funding a child's college education. Retirement planning is important to saving for college, as the time between paying for college and retirement of the parents may be important to the acceptability of the parents taking out loans to cover part of the costs of a child's college.

What Will College Cost in the Future? The tuition increases of the past 10 years are not sustainable -- if the price of anythi ng increases much faster than wages, eventually the entire national income would be devoted to that product. Frank (1994), Pennar (1995), and Weagley (1995) all suggested that the rapid increases in college tuition in the past 20 years might not persist in the future. Colleges may not have unlimited power to increase tuition, and only 5% of students in 1994 attended colleges with annual tuition over $15,000 (Topolnicki & O'Connell, 1994).

In this article, the assumption in examples given is that tuition will increase at the rate of general inflation. However, none of the conclusions in the article are changed by changing the assumption about how fast tuition increases. The possibility of continued rapid increases in tuition makes the case for more aggressive investing stronger.

JEL Classification: G12

Suggested Citation

Hanna, Sherman D. and Chen, Peng, Efficient Portfolios for Saving for College. Financial Counseling and Planning, Vol. 7, 1996. Available at SSRN: https://ssrn.com/abstract=68728

Sherman D. Hanna (Contact Author)

Ohio State University (OSU) ( email )

1787 Neil Avenue
Campbell 265D
Columbus, OH 43210
United States
614-292-4584 (Phone)

Peng Chen

Ibbotson Associates ( email )

225 North Michigan Avenue
Suite 700
Chicago, IL 60601
United States
(312) 616-1620 (Phone)
(312) 616-0404 (Fax)

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