Is Dave Ramsey’s Investment Advice Misguided?

Editor: We’ve since put our S&P 500 trailing returns calculations into a tool you can use.

Dave Ramsey is a controversial figure in the Finance realm, at least in blogs (and blog comments), discussion boards, and other mediums where personal financial mathematics are discussed.  However, Ramsey’s controversy doesn’t generally come about from his investment advice – most of the push-back comes from his advocacy of a psychological debt payoff method known as the “Debt Snowball”.  The Debt Snowball is a form of debt pay-down where you pay off your debts in the order of the lowest account balances regardless of APR (a method which is easily shown to be mathematically inferior to “highest effective interest rate first”.  Psychology?  Beats me.).

I digress.  Anyway, the battle doesn’t usually extend to Dave’s investment advice.  That’s why I was surprised to see the angry reactions to Dave Ramsey’s recent tweet about how $100 invested a week would turn anyone into a millionaire in 40 years if they averaged 12% returns  (he also later linked to a fund which returned over 13%).  To be exact?  A $1,176,000aire.

Saving only $100 per month from age 25 to age 65 at 12% growth = $1,176,000. Everyone should retire a millionaire!

February 12, 2013 5:26 am via TweetDeckReplyRetweetFavorite

@DaveRamsey

Dave Ramsey

Who is Dave Ramsey?

Mr. Ramsey is one of the most famous Personal Finance authorsin the field today, and an esteemed TV guest and radio star to boot.  He had a checkered past as a real estate investor and filed for bankruptcy soon after the Tax Reform Act of 1986 passed.  From 1984 through 1996 he was a licensed insurance agent in Tennessee.

His Personal Finance empire is the outcropping of financial counseling he started for couples at his church.  He started to attend seminars and eventually developed his own style and methods… which rounded into the Dave Ramsey cult of personality that exists today.  Bestselling author, radio host, TV personality, Christian?  You better believe that a lot of people have an opinion about him.

 

Dave Ramsey’s Investment Advice

Most people took exception to Dave’s return figure – the 12% number (here’s one angry reaction from Mandi Woodruff at Business Insider).  Now, the S&P 500 may have returned 16% last year, but everyone reading this obviously still remembers the issues with the stock market a few years ago.  Remember that huge drop?

So, was 12% too optimistic?  Lucky for you, this was a question we were born to answer!

Last year we developed a tool to let you figure out the returns of the S&P 500 over any time period using data provided by Robert Shiller on his website.  Now, that tool is great – but we have better ways to play with that data (namely, by tossing it into a spreadsheet program and crunching some numbers for you!).  Let’s evaluate Mr. Ramsey’s comment with the S&P 500 in mind… the most popular benchmark in the United States, which also happens to have tons of index funds and mutual funds and other ways to invest in it.  It’s fair to say that most people have access to an S&P 500 index fund or some other means to invest in the index’s components.

The S&P 500′s Trailing 40 Year Geometric Average Returns

Graphed above are the 1,224 40 year periods in our data-set, which we built by including every month which Shiller had data on dividends and S&P index prices from January 1871 until today (as of February 12, through December 2012).  The number shown is the geometric average return of reinvested dividends over that period, and I calculated both nominal return and real (inflation-adjusted) returns, using the CPI reading also provided by Shiller.  (A note on methodology: if you reproduce the set, when you count dividends makes a difference.  I also assume 0% taxes and $0 transaction fees.  Coase would be proud.)

You don’t even need to see the numbers to recognize that there wasn’t any period in the data-set with over a 12% real return.  There are, however, periods with nominal returns over 12% – 68, to be exact (5.56% of the time).  Here’s a summary of the results:

Nominal and Real S&P 500 40 Year Returns Presented in an Ordered Set

Here’s that same graph ordered from lowest returns to highest returns, so you can see just how rare 12% trailing returns were on the S&P 500 over the last 102 years:

Now, assuming that most people are talking about the S&P 500 when they talk about the market, it’s just as rare to have 12% trailing returns as returns less than 6%.

Misguided Complaints about Mr. Ramsey?

Okay, so 12% returns are a little too ambitious.  If you retired in December 0f 2012 after 40 years in the markets (defined as the S&P 500, of course) you would have experienced geometric averages of 9.68% nominal and 5.16% real returns.  And, what if you invested $100 a month starting in December 1973 (and reinvested dividends) in a magical fund with no transaction fees and no taxes that tracked the S&P 500 index perfectly (don’t look for that fund – it doesn’t exist)?  I did the math for you – you’d have $636,758.95.

It begs the question, however – why would we get mad at Dave’s tweet encouraging financial discipline?  It seems that, perhaps, you shot for the stars and ended up on the moon.  Isn’t that better than earth?

(And before you ask – goal seek already calculated that to get to $1,000,000 with that fantasy fund you would have needed to invest $157.05 a month).

Dave Ramsey Was Right

Okay, not about the 12% thing.  However, “Everyone should retire a millionaire!” rings true.  If you aren’t investing now, get on it.  I don’t care how you do it – a giant lump sum, periodic monthly investments – just put your money to work for you.

Even if you don’t make 12% over a career, you’ll still have a lot more money than if you try to start a flame war with Dave (or OVER Dave, if you find the right fans) on Twitter.

Although, that would be hilarious.  Link to it here if you can pull it off.