You commonly hear, “Dave Ramsey is great on debt, not so much on investing.” To his credit, he does advocate that everyone who is debt-free saves 15% toward retirement, which is a great start. But listening to his specific investing advice sets the expectations of the portfolio growth too high and will likely cause the investor to take on too much risk.
Dave Ramsey’s investment advice for everyone is to invest in four types of mutual funds:
This portfolio recommendation is virtually all stocks (growth and income could include some bonds or other classes of investments), which is highly unconventional advice. Most financial planners recommend a mix of stock and bonds (and other investments) that becomes less risky (and consequently have lower expected returns) as the investor approaches the date he will need to start drawing down the money. By the time the investor retires, the portfolio may have approximately equal amounts of money invested in stock and bond funds, whereas Dave Ramsey would still have the investor near 100% in stocks.
While Dave Ramsey’s recommended asset allocation may result in higher returns over the long term, it leaves the investor vulnerable to market downturns that could halve the portfolio, as we saw in 2008, and jeopardize the income of the retiree. With a more conservative investment allocation, the investor is somewhat protected from those downturns and the income will not be as affected. The balance between desired high returns and low risk is why most investing strategies start out heavy in stocks and slowly become more conservative as the needed date draws closer.
12% Rate of Return
In The Total Money Makeover, in Financial Peace University, and on his radio show, Dave Ramsey consistently uses a 12% rate of return when illustrating the power of compound interest and predicting future portfolio balances. While it is certainly exciting to see how compound interest can magnify a portfolio over a long timeline, using a 12% annualized rate of return to predict retirement account balances is irresponsible. Thankfully, Dave Ramsey’s advice is to save 15% toward retirement, but late starters may be led astray by that high predicted rate of return and come up short at retirement.
Dave Ramsey’s touted 12% rate of return figure got quite a lot of attention a few months ago when some financial advisors publically challenged it. A Twitter debate, a radio interview, and countless articles and blog posts followed, with Dave Ramsey saying that his chosen fund mix does return 12% annually on average and basically everyone else saying that high rate is unattainable on a long-term average. An analysis using Morningstar data showed that the mix of funds Dave Ramsey recommends have an annualized rate of return of 7.6% over the last 20 years. This figure may be low in comparison with the same from a longer timeline because we have experienced two recessions in the past 20 years, but what if these particular 20 years were your peak saving years or your retirement years?
Even an all-stock investor should use an estimated annualized rate of return closer to 9 or 10% before factoring in inflation, and one with a more conservative mix of stocks and bonds should expect and even lower rate of return (but also lower risk). That 2-3% difference doesn’t sound like much, but when it’s compounding it really makes a difference in returns.
I like that Dave Ramsey is inspiring people to save by illustrating the power of compound interest, but he could be just as inspiring by using 8 or 10% instead of 12% (the lower balances only seem small when compared with the higher).
When many fee-only financial planners are now advocating no-load, low-expense ratio mutual funds, Dave Ramsey recommends front-loaded funds that you must pay an advisor to buy and that have expensive ongoing operating costs. When it is now widely known that passively managed funds outperform actively managed funds 80% of the time, Dave Ramsey still recommends actively managed funds, for which you are paying for the privilege of underperforming an index. I have even heard Dave Ramsey say on his radio show that buying ETFs, the even lower-cost alternative to index mutual funds, discourages people from buying and holding because they can be traded like stocks, which seems a flimsy excuse.
While Dave Ramsey’s recommendation of using mutual funds is certainly a step up from recommending an individual stock-picking advisor, it’s not as modern or efficient as a strategy of passively managed or index funds or at least no-load actively managed mutual funds.
Even if you assumed that the types of funds Dave Ramsey recommends actually achieved the 12% rate of return he touts, your net return would be less the fees charged for those funds, which could be a couple to many percentage points. In the case of the Endorsed Local Provider this journalist visited, the load on the fund he recommended was an incredible 5.75%. That would negate the alleged advantages of using those particular funds and make the 12% figure even more unattainable.
No Variation for the Individual
In keeping with the underlying principles of the Baby Steps, the investing advice Dave Ramsey gives is independent of the individual receiving it – everyone gets the same advice. We already covered that most advisors would shift the asset allocation with the age of the investor, but the risk tolerance of the investor is another important consideration. Being in an all-stock fund is going to be quite a wild ride, and it’s important that the investor refrain from freaking out and selling during a downturn. Many people would be too stressed out by the volatility of the stock market, and they should not be so aggressively invested.
Even if you want to follow the Baby Steps in their order and specificities, you should not take Dave Ramsey’s investing advice without at least investigating the other options: working with a fee-only financial planner (not a commissioned salesperson like the ELPs) or creating your own portfolio (of no-load passively managed or index funds).
Do you use actively managed mutual funds and have you ever bought a load fund? What rate of return do you use when estimating your retirement account balance in the future? What do you think about being in all-stock funds for your entire life?
photo from Free Digital Photos