Thursday, April 30, 2015

Why Dave Ramsey's 12% average annual growth rate is misleading and dangerous for financial planning

[I'll state up front that my family has used Financial Peace and I've taught its principles to others. I highly recommend Dave's method of zero-based budgeting for households, my family has used it for years. My intent here is simply to point out something in the Financial Peace curriculum that is false and consequential. The church is to be the "pillar and support of truth" (1 Timothy 3:15) so I believe if we spot an error we should point it out.]

I recently reviewed B. Chase Chandler's Wealthy Family, in which he criticizes his Nashville neighbor and fellow financial adviser Dave Ramsey for providing a false expectation of returns on investment.

Ramsey provides a defense of the 12% on his website. It's about the average annual return on the S&P 500 from 1926 to today. I agree with Chandler that "I do not think he currently comprehends
how severely his advice is damaging his followers’ longterm financial strategies." Chandler provides a stylized example (p. 127): Suppose you invest $1,000 and earn 55% return the first year (you're up to $1,555), then -37% the following year (now you're down to $979.65). Your average rate of return was a whopping 18.5%, and yet you lost $20.35. If you've lost money, do you really care what the average return is?

Evidence that Ramsey does not realize his error is found in the latest version of his Financial Peace University videos in Chapter 7 "Retirement and College Planning." (I watched this last night as I'm coordinating a FPU at a local church.) While discussing market volatility, he says in the tech bubble of the 1990s he was in a fund that earned 110% one year and then lost over 50% the following year, and he recognized that he ended up right back where he started. He then says something like "the fund earned over 18% over those years but it was a roller coaster to get there." Indeed! But he never logically deduces that counting on a 12-18% average annual return doesn't mean he has to end up with more money than his starting point.

This causes serious problems if you're using 12% annual rate of return to figure out how much you need to save for retirement or your kid's college. One recent study estimated the average American retiring at age 65 needs to have 11 times her working final salary saved to make retirement (plus Social Security) last her expected lifespan.

Chapter 7 of Financial Peace opens with the example of a married couple who invest $600/month in an IRA growing 12% annually for 40 years. They invest a total of ($600 x 12 x 40) $288,000 and see their fund grow to $7,058,863 . Dave then calls this example "a loser" (ie: conservative) because they never increased their monthly contribution. (He writes that if they'd instead fully funded a Roth IRA at $10,000/year [$833/month] they'd end up with $9,803,937.)

What's the problem with this example? First, Dave is using a future value calculation that assumes monthly compounding of interest. That is a mistake when using an average annual rate of return. His example is making the actual return even greater than 12% every year. ($100 deposited today at 12% annual interest compounding monthly nets you $112.68 after one year, a 12.68% return).

Second, as in the above example of Ramsey's tech bubble years, just because your average annual growth rate was 12%, does not mean you made money. What is needed is the compound annual growth rate (CAGR). This website uses historical data to help us out. Suppose you had invested $1 in the S&P 500 on January 1, 1926. Assuming 12% average annual growth as Ramsey does, you end up with $24,011. But using the historical return of the S&P 500 each year (assuming you reinvested your dividends) you would have had only $5,425.86 at the end of 2014. That's a huge difference! That annualized return (CAGR) was 10.14%, not 12%. Two percent makes a big difference when you're calculating growth over time!

So, key takeaway, investing with a 12% average annual return did not net you 12% as your actual annual return.

But if inflation averaged 10.14% over this same time period, your money only just kept its value. The MoneyChimp site also lets us adjust for inflation from 1926-2014. In real terms, $1 invested grew to $413.64. Inflation alone shrunk the average return from 12% to 9.01%, and the CAGR from 10.14 to 7%.

So, 7% is a much better number to use.* Except....

Lastly, Ramsey neglects to mention that fees will eat away at the couple's return. Remarkably, he does not advocate index funds, which have the lowest fees and have been shown time and again to beat actively managed funds over any period of time. His couple above that invested in pre-tax 401(k) plan will likely pay when they receive disbursements, and that also eats their return.

So, let's say fees and taxes reduce our inflation-adjusted CAGR to 6%. What difference does it make for Ramsey's example of a retired couple above?
$600/month at 6% annual growth for 40 years (not compounded monthly) nets just under $1.2 million. Significantly less than the $7 million they were hoping for, and that's before taxes!

A more urgent example: Suppose you have a newborn who you want to go to college at 18 and you want to have $50,000 for tuition in 10 years saved for her in a 529 plan. How much do you need to put in annually with a 12% return (CAGR) versus a 6% return? With a 12% return, $900/year can do the trick. With a 6% return, it's about $1600/year. If you'd invested $900/year expecting 12% but getting 6%, you'd have only had about $28,000 saved. So, this matters for your financial planning!

(Disclaimer: I acknowledge there may be some math errors on my part here, but I stand by the analysis. If you spot an error, let me know and I'll correct it.)

*Note that past performance of the market is no indicator of future success. What period we include in our starting point matters significantly. We could back-test to the 1800s if we want to. Dave uses 1926 as his starting point, but the S&P 500 wasn't created until 1957. Is he hiding the ball?

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