Dave Ramsey's 12% Investing Target Not Relevant
I like Dave Ramsey. I’ve thought about teaching his courses, yet, there’s something about being a NAPFA advisor that generally means one is fiercely independent. We don’t like to be told to give information we may not agree with.
While I enjoy Dave as an entertainer, and recommend his debt repayment ideas since they recognize the value of the emotional victories for those with debt issues, there are several areas his financial information is not the best to plan by.
As a fan, I was a little shocked to see the title of his latest Investing Minute e-newsletter was “How to Earn 12% on Your Investments.” It was only a little shock because I know he has used the 12% figure as what one may earn on stock mutual fund investments, which he claims is “based on the history of the S&P 500.”
Dave’s been challenged on this in the past by other advisors and news organizations. By not addressing the criticism I thought he was letting the controversy fade away. I attempted to contact the Lampo organization for clarification on their methodology prior to posting this blog, however have not received a response.
What may be shocking to many is that I’m not all that disappointed in the fact he thinks stocks can return 12%; he could easily offer an explanation. I can even do it for him:
Excluding the recent decade and going back to when he started to find success as an author the S&P 500 market average was in fact over 11% since 1926, and for many time periods averaged over 12%. We may average out to that point again.
He could make the case that he includes small cap, foreign, and a value tilt, which may push the return higher. A small and value tilt as measured by Dimensional Fund Advisors US Adjusted Market Value Index would have resulted in a 11.8% annual return since 1928.
He could believe that actively managed mutual will beat the market (though I’d disagree, at least it would be an argument).
The problem I see is that he doesn’t appear to make those cases. In fact, it appears from the comments in the newsletter that he may be changing the numbers he relies on, but not the claim. Below I’ll detail a few reasons why Dave’s claim of 12% is not achievable; others have offered more detail on this topic as well.
This website link drew a lot of attention for claiming that since the S&P 500’s “inception” of 1926 (the S&P 500’s first publication was actually 1957, though I’m OK with using back-tested numbers) the index returned “11.84%.” It has been shown by others that the actual return on an annualized basis is closer to 9.9% (Dave’s method appears to take a simple average of the returns, which does not reflect how investors would have done).
The new email doesn’t mention 1926, instead referring to 12% being “based on” the S&P 500. It seems to recognize a different starting point described as the “58-year history of the S&P.” Since I can’t be sure what that means (the S&P 500 has been in existence for 54 years), I have to assume that Dave is using extended data.
Is it possible over this time period that we averaged closer to 12%? If we go back before the beginning period of the S&P 500 by 4 years as Dave’s number appears to, we see a few exceptional years for the markets. In 1954 the S&P returned 52.6%, while in 1955 it achieved 31.5%. Having returns like this as a starting point would pump up the ending return (2010) by approximately 1% to 10.7% over starting in 1957. Another starting point during the year may increase that, as would selecting a different ending point. Again, the point here is we can’t know what time periods are being considered, but it varies based on which are chosen.
Even though the new email simply muddies the waters about what data Dave is actually looking at, my problem isn’t even that he chooses to stick to this 12% number, it’s that he leads investors to believe 12% is a number that matters when it doesn’t.
What is important is the return that investors achieve after inflation, expenses, and taxes. In looking just as the after inflation number, we noticed something fairly interesting. The ‘real return’ has been roughly 6.7% from 1926 to 2010, and 5.6% from 1957 using calendar year returns less CPI as a proxy for inflation. Note that the real return since 1926 is almost 1% per year higher, a fairly material difference in terms of returns, and yet the nominal return was almost identical (9.9% annually since 1926 versus only a slightly lower 9.7% since 1957).
What we see in many emerging economy stock markets can make the point even easier to grasp. Is it a good thing that the Zimbabwe exchange may rise several hundred percent, when inflation rises several hundred percent right along with it? The nominal rate of return doesn’t matter whether it is 12% or 2,000%. It’s what that money can buy that matters.
Individuals are risk adverse. Just like Dave advises that paying down debt should be done in the debt-snowball manner because it places the emotional victories above the financial; so too should an investment plan recognize that individuals emotions play a large part in their willingness to accept investment risk. The vast majority of individuals are not going to invest in a 100% stock portfolio, which again makes the number fairly meaningless. I’ve met too many who listened to advice like this who pulled out of the markets after losing half of their life savings, locking in those losses for their lives.
The 12% number, possible or not, has little meaning; but, it is also not realistic to plan by. My biggest disappointment with this mailing from Dave’s camp is that instead of conceding that point, it doubles down on trying to prove it is possible. About a year ago I made the decision to start a firm as I’ve been a witness to how prideful advice can destroy portfolio returns more than bad investments. I hope Dave at some point reconsiders the advice he shares with those who live by what he teaches.
The preceding blog was originally published by Forbes. To view the original blog please visit our blog at Forbes. http://www.forbes.com/sites/feeonlyplanner/