There are a lot of
personal finance gurus out there that give sensible advice, that if followed,
leads to a better life. But every once in a while they say something incredible
and disingenuously false that ruins their credibility. One of those is Dave Ramsey
and is 12% returns. You too can retire a millionaire. Just invest $100 per
month in a good growth stock mutual fund that I recommend.
Dave Ramsey's 12% Returns
If you follow all of
Dave Ramsey's advice to the letter you will be much better off financially, and
probably as a person, than if you don't do any of the things he recommends. But
one thing that he says that makes him less credible is that with "a good
growth stock mutual fund" you will earn around 12% annually. Investing
$100 a month into the fund for 40 years, say from the time you're 25 until the
time you're 65, you will retire a millionaire.
Here is the claim on
his website, where the data is from 1923 to 2016. The range may change by the
time you read this as Ramsey's website is updated.
Putting aside the
issue of the fees associated with the funds that Ramsey recommends and
presumably gets a commission from, this is kind of disingenuous if you think
about it.
Depending on the
time frame that you pick, the S&P 500 has averaged around 12% annually. For
example, from 1923 to 2016, a 93 year period, the S&P 500 has averaged an annual return of 12.5%. The key
word here, however, is "averaged."
An average annual return is different from a
compounded annual return.
Here's a simple
example. Suppose a $10,0000 investment goes up 50% the first year and down 40%
the next, and this pattern repeats every year. So, the investment grows to
$15,000, then falls to $9,000, and so on:
Actual Investment
|
Year
|
Starting
Value
|
Rate
of Return
|
Ending
Value
|
|
0
|
10,000.00
|
50%
|
15,000.00
|
|
1
|
15,000.00
|
-40%
|
9,000.00
|
|
2
|
9,000.00
|
50%
|
13,500.00
|
|
3
|
13,500.00
|
-40%
|
8,100.00
|
|
4
|
8,100.00
|
50%
|
12,150.00
|
|
5
|
12,150.00
|
-40%
|
7,290.00
|
|
6
|
7,290.00
|
50%
|
10,935.00
|
|
7
|
10,935.00
|
-40%
|
6,561.00
|
|
8
|
6,561.00
|
50%
|
9,841.50
|
|
9
|
9,841.50
|
-40%
|
5,904.90
|
|
10
|
5,904.90
|
50%
|
8,857.35
|
In the last year,
the investment is valued at $8,857.35, for a total loss of $1,142.65 or 11.43%.
The average annual return
for this investment over the 11 years, however, is a positive 9%!
Let's say I'm trying
to sell you this investment and I say, on average it returns 9% per year.
That's true! But here's the disingenuous part. I say next, so if you put in
$10,000, and you average 9% per year, your investment will be worth $23,673.64
in ten years:
Investment as Marketed
|
Year
|
Starting
Value
|
Rate
of Return
|
Ending
Value
|
|
0
|
10,000.00
|
9%
|
10,900.00
|
|
1
|
10,900.00
|
9%
|
11,881.00
|
|
2
|
11,881.00
|
9%
|
12,950.29
|
|
3
|
12,950.29
|
9%
|
14,115.82
|
|
4
|
14,115.82
|
9%
|
15,386.24
|
|
5
|
15,386.24
|
9%
|
16,771.00
|
|
6
|
16,771.00
|
9%
|
18,280.39
|
|
7
|
18,280.39
|
9%
|
19,925.63
|
|
8
|
19,925.63
|
9%
|
21,718.93
|
|
9
|
21,718.93
|
9%
|
23,673.64
|
That's not true.
Why? Because average and compound average returns are being conflated. But as
you can see above, there's a big difference.
I'm not sure if
Ramsey does it on purpose or not, but he makes the same conflation. He uses the
historical average return of the market to forecast a compounded annual return.
This makes his advice look much better than it is, and if you realize this you
might start to question everything else he says.
So what are the real
numbers?
From 1923 to 2016,
the S&P 500 has averaged 12.25% per year. Investing $100 per month for 40
years would have produced a portfolio valued at $996,927.31 if the 12.25% were
compounded.
The actual compound
annual growth rate of the S&P 500 during this same period was 10.34%. That
is seemingly not such a big difference from 12.25%, but it is huge (and is also
why fees matter so much!).
Investing $100 per
month for 40 years and having that compound at 10.34% would have yielded a
portfolio of $587,779.81, which is a $409.147.50 difference from the advertised
amount! And this doesn't factor in inflation or fees.
The saddest part for
me is that this might reasonably lead one to conclude that Dave Ramsey is full
of crap and that everything he recommends doing is worthless. I don't
understand why he doesn't use the actual compound returns, they are even provided in the MoneyChimp calculator link on his website) and increase the
monthly investment amount to compensate. A hundred dollars a month sounds a lot
easier than three or four hundred, I guess.
