4 things Dave Ramsey is wrong about investing
Dave Ramsey is best known for his anti-debt crusade: Cut up your credit cards. Live without a credit score. Take her baby steps and you might be able to scream that you’re debt free from her Financial Peace Plaza in Brentville, Tennessee.
Ramsey is less known for his investment advice, but he has a lot of it – and it’s often based on fuzzy logic and questionable math. Here are four things Ramsey is wrong about investing.
1. Get rid of all non-mortgage debt before saving for retirement.
In Ramsey’s Baby Steps, saving for retirement only happens when you have no debt other than a mortgage and has a term of three to six months. emergency fund.
But investing while you are in debt makes sense when you can earn more than what you pay in interest. Tackle credit card debt at 14% APR before investing will pay off. But not to invest because you have a car loan at 3%? Absurdity – especially when you can increase your yields more with a 401 (k) corporate correspondence.
The cost of deferring retirement savings is astronomically higher than the minimum interest payments, especially if you are between the ages of 20 and 30.
2. Invest in entry fee mutual funds.
Ramsey wants you to invest in mutual funds with entry fees, which means you pay an upfront commission. If you invested $ 5,000 in a fund with an initial charge of 5%, you would actually invest $ 4,750. Ramsey’s argument: The upfront costs are transparent and translate into lower maintenance costs.
But if you want low maintenance costs, why not invest in a exchange traded fund? ETFs tend to have the lowest fees as they are generally passively managed index funds. More mutual fund, on the other hand, are actively managed and human management does not come cheap.
Ramsey says he don’t like ETFs because he’s a buying and keeping guy. Unlike mutual funds, ETFs trade on an exchange. So what should a buy and hold ETF investor do? Easy. Buy the fund and keep it. No need to pay a commission to stop you from day trading.
Ramsey also loves fees because they buy you the wisdom of an investment professional. (Conveniently, he has an extensive network of referrals from investment professionals). But with time the most active managers underperform compared to passively managed index funds after fees.
3. You can earn 12% return on your investments.
Ramsey says when he tells people that they can expect 12% returns, it “uses an actual number based on the historical average annual return of the S&P 500” over 80 years.
But Ramsey’s calculations are problematic for several reasons.
Average annual returns don’t tell you anything about your actual returns. Let’s say I invest $ 1,000 and earn 100% return in the first year, which means I doubled my money. The second year, my investment drops by 50%. After two years I was making 0%, but my average annual return was 25%.
Now let’s say my $ 1,000 investment returned 25% the first year and 25% the second. My average annual return was 25%, although I now have $ 1,562.50, a gain of 56.25%.
The compound annual growth rate (CAGR), which represents the closing balance, is a better number to use when evaluating an investment.
Ramsey also ignores inflation, which is typically around 2% per year.
Using the CAGR and assuming that all dividends have been reinvested, the S&P 500 produced inflation-adjusted annual returns of just over 7% between 1940 and 2020, according to data from Yale economist Robert J. Shiller.
4. You can withdraw 8% per year upon retirement.
When you’re 75 and retired, you usually can’t afford the risk level you might at 25. If you have nightmares when the S&P 500 drops 100 points, you have a tolerance for risk. lower than that of options traders on Robinhood.
Taking less risk obviously reduces your returns. But Ramsey preaches 12% as a magic number that you should always aim for, regardless of your age and personal risk tolerance. And retirees should expect inflation of 4%.
12% -4% = Ramsey’s estimate that you can withdraw 8% from your portfolio each year when you retire.
Ramsey thinks you should always be 100% invested in stocks. Although overly cautious allocation is a common practice investment error in retirement, when you don’t earn any more income, you can’t afford as much risk as you could when you had 20 or 30 years of work left. While it is not a good idea to completely withdraw from the stock market after retirement, your asset allocation should change to include bonds as you get older.
The 4% rule for retirement withdrawals that financial planners have traditionally adopted may be overly cautious. But withdrawing 8% per year makes you very vulnerable to a stock market crash during your retirement years.
What Dave Ramsey achieves
All of that said, Ramsey Is have a lot of wisdom. Eliminating debt will help you avoid outliving your retirement savings. His message about living within your means is strong.
But it is important to make investment decisions based on reality. You can’t count on consistent returns of 12%, especially in retirement. Adjusting your expectations is essential to achieving the financial peace Ramsey preaches.