A Twenty Million Dollar Tale

Dr. Evil

Image via Wikipedia

A Twenty Million Dollar Tale

“Is College Worth It?”

I have a strong belief that a college degree is a critical component to financial success since we know that college graduates earn more income than their non-graduate peers. It is a type of filter for future employers that begins when the student completes the eleventh grade. I would argue however, that the reasons that motivate people to attain their college diploma are the reasons they are more successful and not because of the diploma. If you’ve seen the movie The Wizard of Oz, there is a scene where one of the characters, The Scarecrow, gets bestowed with an honorary diploma from a wise person called the Wizard of Oz. It’s is a fantasy scene because as soon as The Scarecrow got his diploma it seems he is instantly transformed from dunce to genius. Like the Scarecrow from the movie such is the fantasy about the college graduate. The reality is the Scarecrow was wise and Oz just confirmed it. The reality is that colleges preselect the best and the brightest and these “pre-selectees” would do well in any environment.

Why do people go to college? College is certainly not the only path to financial success nor is it a guarantee to financial success but throughout the last 100 years or so it has proven to be a consistent, safe and reliable path.  It has provided opportunity. This is the reason why so many immigrants, Cubans included, gravitate towards degreed professions. Within my family alone I have not one first cousin that doesn’t have at least a college degree. To further illustrate the point, every one of my first cousin’s children including my own that are over the age of 23 also has a college degree. To say that the history of my family is to believe in education is an understatement. We have a long history of overpaying for education. But is college today worth the money you pay and if so, what are you really paying for?

Let’s examine the facts. I live in Maryland and I have 4 children. The cost to attend the University of Maryland is roughly $25,000 per year when you factor in all expenses. This represents a $100,000 investment over 4 years. What does this mean in financial terms? The analysis is very simple. You simply compare an alternative use for this capital such as investing the money instead of education. The results are startling and the table below points it out in vivid detail.

From looking at this table a parent can gain many insights. Spending $100,000 on a college degree may from a rate of return perspective be worth it if your child is wildly successful but it’s highly unlikely. Just ask yourself the question how many college graduates retire with a net worth in excess of $5 million to see why I say it’s highly unlikely. If a parent has as a goal to insure that their child can retire in comfort at age 65 they would be much smarter putting the money in a low cost stock index fund that historically has earned about 12% and insuring that 47 years later their child is worth almost $20 million dollars, thus the title of this tale.

To make matters worse, I attended Johns Hopkins University, another school in Maryland, and the cost today is double that of the University of Maryland. At a 12% rate of return a parent could insure that their child has almost $40 million dollars at age 65 instead of attending a prestigious private school. These numbers are compelling.

Can we glean anything else from the table? We can of course see once again the magic of and that rate of return matters. We can see that if you double the rate of return from 6% to 12% over the 47 year period that you increase your ending capital by a factor of 13, instead of approximately $1.5 million you have $20 million. But is there something else we can glean from this? I think so. I break it down into 3 categories. The first is parents that can afford to pay for college and are aware of the magic of compounding. The second is parents that can also afford to pay for college but are unaware of the power of compounding. The third is parents that can’t afford to pay for college so they don’t have an alternative use for college funds because they don’t have the money in the first place. Each one of these parents sees the college value proposition from a different lens.

Parents in the third category see college as an opportunity for their children and to them college is a no-brainer. If their child can go to college they want them to attend. The same holds true for parents in the second category. Since they don’t understand the power of compounding they are taken in by the propaganda that college grads make more money and to them college is also a no-brainer. But what about the parents in the first category. These parents are people such as myself and most of my clients. We know that college is a poor investment since we are the ones most likely to be able to achieve a 12% rate of return, yet we persist. We keep sending our children to college. We keep overpaying for education. There are probably as many reasons for this as there are children in this category. Perhaps we want our children to help humanity or seek some level of self actualization that they can only attain by the 4 year process. Perhaps it’s peer pressure. In any event, parents in this category don’t send their children to college because college graduates earn more money than non-college graduates. They have other reasons.

My advice to parents and children as they embark on the college selection process is that you are jointly aware of the long term financial implications of your decision. There are no right or wrong answers as far as I am concerned but informed answers. Make sure that your child knows what is expected and why. Make sure they aware of what they are giving up in terms of financial security if they attend so that they take college as seriously as they should. Let them understand that they are getting a $20,000,000.00 education.

RSS Financial Tales

4 Comments

  1. I ran these numbers about six years ago when my kids were getting ready to attend college. I think a fairly high percentage of parents out there are actually in the category where the cash isn’t available to make the investment rather than sending them in the first place, so it’s a little tough to execute.
    The other thing that the numbers don’t really take into account, however, is that someone without a college education is very likely to struggle along from paycheck to paycheck, living on credit cards, and not enjoy the quality of life or satisfaction in their career as those who do have the degree(s). If given access to a trust fund of the college money, they’re going to spend it rapidly, never allowing it to compound.

    I love your site; wonder why no one else seems to comment on things here.

  2. Pingback: To the Class of 2010: Graduation Day « Cash Flow Sherpas | A Personal Finance Blog By GreenSherpa

  3. Pingback: Financial Articles and Personal Finance Advice from Personal Finance Blogs - November 8 2008 | Personal Investment Management and Financial Planning Blog Directory

Leave a Reply