How to Think About College as an Investment

We have behavioral biases in all of our decision-making – it is what makes us human. Nowhere is this more evident than in our decision to invest anywhere from $100,000 to $200,000 in a college education for our kids. With most investments we will at least look at the possible return on investment (ROI) and consider the risks involved. If we do happen to consider the same factors when evaluating higher education that we do with a “normal” investment, our behavioral biases are so strong that they tend to override any objective analysis.

But if we are aware of our own decision-making flaws, we are more likely to be able to make better decisions. As the holidays approach, I know I have my own flaws when dealing with certain family members and as a result, I mentally prepare myself before interactions. This helps my decision-making process. (For more, see: 4 Behavioral Biases and How to Avoid Them.)

Behavioral Biases

Behavioral economics can offer some insight into our view of college. Two behavioral biases that may be contributing factors are representativeness and simulation.

With representativeness bias we judge things to a preexisting model in our mind. In the case of choosing to go to and to fund college, the existing mental model may be that in order for our children to be happy they have to go to a nice school. That model has been ingrained in use since we were kids. College leads to job, job leads to money, money leads to stability, stability leads to a good mate, a good mate leads to kids, and kids mean the family line continues. Everyone is happy.

I tend to think that the behavioral bias that affects us most in regards to college funding is simulation. We assume that those with degrees from prestigious schools have happy lives and we are envious. We want our children to have that perceived happiness. Envy is an easy behavioral bias to implement. It requires no imagination. It requires little effort to ignore an alternative path. (For more, see: Behavioral Finance: How Bias Can Hurt Investing.)

The scenarios that we are comfortable with have greater weight in our minds, regardless of the evidence. We will instinctively reject the unusual, or will not evaluate evidence supporting the unusual objectively. We will also ignore evidence that does not support the usual. The harm that can be created not just in paying too much for college but also in the “usual” way we pay for college is evident in the nation’s student debt problem.

The common thread between the two of these behavioral biases is that they are the paths of least resistance in our decision-making process. When confronted with a difficult or unknown problem, it is natural for a mind to resort to rely on these biases. It is a quick and easy way to make decisions.

Performing tasks with little thought can make us efficient and more productive. Successful people often use habits to efficiently get things done. It is why Steve Jobs wore the same clothes every day. It cut down on the decisions he had to make. We all have mental budgets. If we don’t have to think about what to eat, what to wear, if we get up at the exact same time and do the exact same workout, it becomes habit. We accomplish routine tasks with little effort. We are free to focus on other things, like work or family.

It may also be an extension of our fight or flight response. If we see a lion, we want to run away very, very quickly. We don’t stop and ask, is the lion real? Am I in real danger? Even if you believe the lion is not real, would you take a chance? The same can be true for higher education. We are in the habit of always assuming it is good, regardless of cost. Even with evidence to the contrary, why would we take a chance? (For more, see: Logic: The Antidote to Emotional Investing.)

Costs and Risks

The problem is when these habits become destructive. Bad habits are difficult to break, cemented through years of experience, social and family pressures and easy government lending. Ironically, the use of representativeness and simulation in the college decision-making process means a lot of hard work, passion and motivation may be misdirected.

In order for college to be viewed as an investment, the costs and risks must be weighted against the potential return. We need to acknowledge that we have these biases, objectively look at alternatives both for higher education and the funding of it, and make sure the ROI is worth the risk involved.

There is a measurement in investing called the Sharpe Ratio. It measures a given return for a level of risk taken, a risk-adjusted return. It is a way for comparing investments with different characteristics, comparing apples to apples. An investment might have a lower potential return compared to another investment but may have a higher Sharpe Ratio. It may have a higher return for the level of risk taken.

We need to look at college the same way, asking: What is the ROI, both qualitative and quantitative, of one higher-education path compared to another? What is the College Sharpe Ratio? What is the potential return for risk taken, time involved and debt taken on?

If we can improve our college decision-making process and treat college as an investment, an asset class, we may find that we will make the most of our kid’s hard work and passion and put them in a true position to succeed and be happy. (For more, see: Behavioral Bias - Cognitive vs. Emotional Bias in Investing.)