I don’t know how many of you have heard of Dave Ramsey out there. He’s a fairly popular money guru, especially in the Christian community. I was being provocative with the title, and I believe he is wrong about something and one thing in particular I will talk about below. But the thing about money gurus is that they need to tell a simple absolute story and sound super confident or people just don’t listen to them. Nobody likes to hear, “Well maybe this…”, “Maybe that…” “It depends on the circumstances…” They want, “Never do this!” “All debt is bad!” “You will earn 12% in the stock market!”
The stock market thing really gets me… see the link below. I had to make sure that he was actually claiming this before I wrote this post, but he does.
Saying you are going to earn 12% on your stock market investments is irresponsible and deceptive. I know he’s looking for the “wow” number to get people to start saving, but lying to get people to do the right thing doesn’t sit well with me. Now they claim “ohh no we aren’t wrong, here are the facts”… and they lay out historical return. Okay, here is the thing, they use a simple average of returns to come up with 12%. You just can not do that when talking about investments, any finance person worth anything knows that. Let me give you an example…
You earn –
Year 1 + 12%
Year 2 – 24%
Year 3 + 18%
Year 4 + 18%
Year 5 + 6%
Year 6 + 42%
If you average these together you would get 12%… so you earned 12% a year right? Nope. If you take $1 and earn 12% a year on it for 6 years you get about $2. If you take $1 and earn the series of returns above you only get about $1.78, what happened!
Well the average of a series of numbers, especially ones with negative numbers, don’t quite equal same single number you’d need to come to your ending value. The technical name for a number that gets you to your actual ending return is the Geometric Average. This average takes into the account that if you drop 50% and then you have a 100% return the next year, in reality you are at zero, but the simple average says you had a 25% return!
So that’s the first thing, they are using a simple average and saying that’s what you’re going to earn, that’s just plain bad finance.
The second thing is ignoring inflation. In the past, inflation was a big component of the returns. Average inflation over the last 80ish years is like 3.25%, the average inflation over the last 10 has only been 1.7% (not counting the recent run up). So if you have lower inflation long term you will most likely have lower returns, only because that inflation is kind of puffing up the number.
And third, the valuation of the stock market is a big predictor of what kind of returns it will have in 10+ years. Right now the stock market is overvalued at the very best way of looking at it and extremely overvalued from other perspectives. So it is very unlikely given how things work that the next 10 years is going to produce extraordinarily returns, especially 12% returns!
Okay that all being said, even if the stock market only returns 5% over the next 10 years on average, hey that’s something! What gets me about the 12% number from Dave Ramsey is that it could leave people really unprepared for retirement or mean they don’t meet their goals. For example, you want to save $2,000,000 for your retirement. You listen to Dave Ramsey and think wow at 12% a year over the next 40 years I only need to save $600 a month! But if you take a more conservative number that might be closer to reality say 5% then you need to save $1400 a month. That’s a huge difference!
Everyone loves Dave Ramsey, so I thought I’d pick on him a little :). But be aware that you should always do your own investigation when people are giving you information or advice that could have a meaningful impact on your life! Even well respected people don’t always have the correct information, and this is a great example of that.