Every parent dreams of their kids graduating from college, but the hurdles to get there sometimes feel insurmountable. Not only are college admissions more competitive than ever, but the cost of college is skyrocketing.
Two reports last fall from the College Board said college costs are rising faster than financial aid availability, meaning more of the burden to pay falls on families. And, over the past 20 years, the price of college tuition and textbooks has doubled, according to the American Enterprise Institute.
So, what’s a parent to do?
The answer is clear – start saving as early as possible. But even with saving, there are issues to consider. Though interest rates are slowly creeping higher, they remain near historic lows, making the annual percentage yield on a savings account 1 percent or less. So, stuffing cash into a savings account for the next 15 to 20 years alone is not likely to grow your money fast enough to cover ballooning college costs.
To meet the financial demands of higher education, families will have to think about getting the most out of each dollar saved and the best way to do that is to invest in the stock market. The stock market based on the S&P 500 index returns about 7 percent annually, on average and adjusted for inflation, over the long-term.
The S&P 500 index is a basket of stocks intended to reflect the overall return characteristics of the general stock market. Stocks selected for the S&P 500 are based on market capitalization, industry and liquidity.
A key detail to understand and remember, though, when investing is the dividend component was responsible for 44 percent of the S&P 500’s total return in the last 80 years, according to Standard & Poor’s. That means reinvesting all dividends produced about eight times the return. A dividend is a payment a company may pay regularly (usually quarterly) to shareholders out of its profits.
So, families looking to invest their college savings fund in stocks should specifically look for dividend stocks. However, the type of dividend is just as important. Regular, growing dividend stocks not only have outperformed non-dividend paying stocks but also outperformed shares that only pay a constant dividend rate. According to Oppenheimer, growing dividend stocks outperformed unchanged dividend paying stocks by 2.4 percent each year from 1972 to 2013.
Even better still, with dividend stocks, investors not only gain from stock appreciation but can take advantage of the power of compounding, or what Albert Einstein called “the eighth wonder of the world.” Compounding in the stock world means dividends you earn from your stock investment will generate more earnings when reinvested, or used to buy more shares.
To illustrate the power of compounding, if someone offers you a million dollars today or a penny that doubles in value each day for 30 days, take the penny. That penny will make you a millionaire in less than a month and a multi-millionaire by the end of the 30 days. Of course, this is an extreme example because the value of your stock investment isn’t likely to double each day, but you can get an idea of how dividends and their reinvestment could boost a college savings fund over time.
Dividend stocks are also safer.
Companies that pay regular, rising dividends tend to be financially stable and mature. They likely are profitable and generate a steady cash flow, which means their stocks are less volatile and seen as less risky investments – perfect for a college fund.
Dividends also are a great partial hedge against inflation and drops in share prices. Usually, a dividend is not enough to completely offset an inflation surge or a precipitous decline in share price, but it could help soften the blow. For example, if inflation soars to 10 percent and your stock portfolio return is 7 percent and pays a 3 percent dividend yield, then instead of a negative return, you would be near breakeven. Similarly, if your stock loses 4 percent of its value but pays a 3 percent dividend then you only lose 1 percent of your investment.
Fortunately, many companies make it easy to reinvest dividends. Often, companies offer dividend reinvestment plans, or DRIPs. In a DRIP, any dividends a company may pay will automatically go towards buying more shares instead of in a check to you. So, you never even miss the dividend money.
Enrolling in a DRIP can also save you money. Many DRIPs allow you to buy additional shares without a broker, meaning the transaction is commission-free. And sometimes, the DRIP will even allow you to purchase shares at a discount to the current share price. Certain DRIPs allow shareholders to buy additional shares in cash, directly from the company at a discount that can be anywhere between 1% and 10%.
So, when considering how to handle soaring college costs, give some careful thought not just to investing in stocks but what kind of stocks. It can make a huge difference in the long-run.
By David Chen, owner of Millennial Personal Finance