The Thinking Person’s Guide to Dave Ramsey: Realistic Wealth Building
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.
Unconventional Strategy
Dave Ramsey’s investment advice for everyone is to invest in four types of mutual funds:
25% growth
25% international
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).
Expensive Funds
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
Filed under: investing · Tags: active mutual funds, Baby Steps, Dave Ramsey, ELPs
The Thinking Person’s Guide to Dave Ramsey: Swapping Baby Step Order
The Thinking Person’s Guide to Dave Ramsey: Overview
The Thinking Person’s Guide to Dave Ramsey: Reasonable Baby Step Modifications
The Thinking Person’s Guide to Dave Ramsey: Underlying Principles25 Responses to "The Thinking Person’s Guide to Dave Ramsey: Realistic Wealth Building"
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You’ve covered all the criticisms I have of Dave Ramsey’s investment plan, Emily. And you’re a bit kinder than I would have been…that’s a good thing, considering it’s Christmas.
The one justification I have is that since Dave is so conservative with his debt approach (throw all money at debt regardless of interest rate, once 15% of income is invested) that his followers HAVE to be more aggressive. It makes sense, in a twisted sort of way.
But nudging his listeners to front-loaded, actively managed funds and promising a 12% return is ludicrous. It’s clear that passively managed index funds will beat that strategy. Additionally, his defense stating that he owns certain mutual funds that historically have returned 12% is immaterial. So what if one or a handful of your funds have met that number? ALL of his actively managed funds would have to return 12% for him to justifiably use that metric on the air. I doubt that is the case.
I’d say that Dave has a borderline conflict of interest regarding his investment advice, since he pushes people towards his ELPs. I met with my area’s ELP and was shocked at what they wanted just to draw up a financial plan ($3k up front…all to tell me to buy their front loaded investments). Dave lost me as a listener once I figured out how bad his investing advice was. Good guy, and we owe him a debt for helping us get out of our own debt…but on this subject he is WAY off base.
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I concur that Emil is quite charitable, but overall I think Dave has good advice for getting out of debt, just not such good advice for after.
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That should have been Emily; apologies and merry xmas and thanks for the series Emily.
Brad recently posted..129 Cars | This American Life
You’re very welcome! Thanks for leaving a comment!
I guess you can say that the debt advice is good because it seems to work for a lot of people. I wonder how many are like DBF and bail on the plan when it gets to the investing portion.
I’d love to see your own less kind version of this post! Have you written it or are you inspired to write it?
While you might think on the one hand that someone starting late might have to be more aggressive, you could just as easily argue that they can’t afford to be so aggressive. It’s gambling that you’ll end up with a decent portfolio, when the other outcome is an even smaller one if your timing is unfortunate. I don’t think it’s really the fault of DR’s plan that people are starting late, since getting out of debt is productive and on average it only takes 2-3 years. It’s just that people who use his plan are often in a pretty bad state to start with. IMO his target audience is middle-aged people.
I agree about the suspicion of conflict of interest, which is why I linked to that Money article. I hope people will read it since it is a bit of investigative journalism. That’s interesting (and terrible) that the ELP you met wanted to charge you both ways, for time and commission – I would think that would be pretty unusual.
What bugs me is that when he says “but even if I’m half wrong”– leading folks to think that even if they get 6% return, they’ll get half of his predicted return on 12%… which isn’t true because that’s not how compound interest works. (I have an unfinished post on this deep in our blog drafts.)
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That drive me up the wall!!! I heard him say it in one of the FPU lessons and I was sure to point out the error to my table. It is such misleading phrasing.
Wow, I can believe he claims 12% YOY from the stock market. I thought there was something fishy about him when I listened to one of his podcasts.
On one hand, I think you should give your listeners all the facts, but on the other, I wonder if that fictional 12% return has inspired folks to start investing that otherwise wouldn’t have?
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It’s possible, but I think it does more harm than good. Just use 10%! It will still give amazing results and won’t mislead anyone any more than anyone else is. (I do have an issue when compound interest is illustrated and the impression is given that those are the balances one will achieve in one’s retirement accounts, when really the money is invested in bonds as well as stocks.)
I’ll try to advocate for DR here:
One advantage of overbearing money managers is that they often push products which make it difficult to withdraw money. One of the best ways to lose at investing is to try to time jumps in and out of the market– especially by getting frightened during downturns. I think you glossed over perhaps his most important piece of wisdom: that having the freedom to go off-plan and pick from the ETF buffet encourages people to buy and sell and shop around for the best investments. DR would rather you not think about it, because picking investments is on the slippery slope to market timing. This seems entirely consistent with his debt snowball versus avalanche preference — favoring not-screwing-up over maximizing-efficiency. The same type of people that needed his help getting out of debt may also benefit from such foolproof investment instructions (i.e. not the personal finance blogging community or graduate student population in general).
This advice is also consistent with his mantra that your income is your most powerful wealth building tool — he would rather people focus on increasing wage based income than chasing high returns in the stock market. His investment babystep appears to be limited to 15% of income, right? Maybe your mutual fund holdings are supposed to be the boring part of your investment portfolio? It sounds like he would have you spend the rest of your saved income cash-flowing rental properties or starting a small business.
But yeah, obviously he gets paid by ELPs for a reason.
That’s a really great perspective, Richard. You are so right that DR advocates people going through advisors to invest their money to prevent them from getting out of the market. It is laudable that he advocates buy-and-hold and discourages market timing. If I were to rewrite the underlying principles post, “your income is your most powerful wealth-building tool” should be in there because it applies to several aspects of the Baby Steps, including investing as you pointed out.
[…] Evolving PF: Another great article in Emily’s series exploring alternative viewpoints on Dave Ramsey’s financial advice. This one delivers a really solid critique of his investment advice. […]
Dave Ramsey makes me a little mad for the reasons you say and more. It’s frustrating that a person who has so much power can preach some falsehoods so strongly. I don’t get why he can’t admit his returns are incorrect now…
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I waver between believing that he is very smart and well-informed and thinking that he’s drunk too much of his own Kool-Aid, which I guess are not mutually exclusive. I see him as similar to a person who sells whole life insurance – likely well-meaning but too invested in the wrong answer being true to be able to see their own folly.
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