Ever heard of Dave Ramsey? If not, let me introduce you. Ever since 1992, Ramsey has been helping people get out of debt, start saving, and ensure secure retirement planning.
Ramsey owns a company, The Lampo Group, which focuses on financial counseling. He has written several best-selling books that have likely helped millions of people. He has his own radio show, and he has appeared on the Motley Fool Money podcasts from time to time.
One of my favorite quotes from Ramsey, which sums up much of our collective financial folly, is: "We buy things we don't need with money we don't have to impress people we don't like."
If you don't get the point I'm trying to make, it's that on the whole, Ramsey has done a lot of good for a lot of people. But there's one part of his plan -- which has gotten a lot of attention lately -- that could leave a lot of investors in an unexpected bind when retirement time comes around.
Sound behavioral advice for investing
I'll get to what I think Ramsey's biggest mistake is in a minute. But it's also important to note that much of the behavioral advice he offers when it comes to investing is spot-on.
He pleaded with people not to sell their investments during the Great Recession, he advises getting an investing professional to help you with financial decisions -- especially during volatile market periods -- he thinks your investing horizon should be a minimum of five years, and he's a big proponent of setting a regular investing schedule and sticking to it no matter what. These are all characteristics we Fools embrace.
So what's the problem?
There are actually several problems with Ramsey's advice for retirement planning from what I can see, but first and foremost is this: He encourages listeners and readers to assume that they can expect average returns of about 12%, and that they should use this assumption when planning for retirement.
Back in February, he posted this on his Twitter page:
Clearly, he's not making it a secret that investors should expect to get about a 12% yearly return on their investment. When I tried to find out why he chose 12%, I found this claim on his website: "Dave is referring to the average annual return of the stock market since 1926, which is very near 12 percent annually when adjusted for inflation."
Really? When adjusted for inflation, to boot? I'm not sure what numbers Ramsey is looking at, but this is akin to telling your teenager who is about to attempt a cross-country road trip that they'll only need half a tank of gas to make it.
When we use market returns compiled by Yale economics professor Robert Shiller, we see that the S&P 500, including dividends reinvested, has returned an average of 9.9% per year since 1926. And when we adjust that for inflation, it dips down to 6.7%. That's a far cry from "very near 12 percent annually." Check here if you don't believe me.
The best that I can suspect is that -- for some reason -- Ramsey is using the average yearly return, instead of the compounded annual growth rate (CAGR). That may sound confusing, but consider Ian the Investor, who is investing $100 in the stock market for two years.
- In year one, the investment goes up 100%, leaving Ian with $200.
- In year two, the investment goes down 50%, leaving Ian with $100.
Maybe Ramsey is just averaging out the two returns. If you take 100 (the first year's returns) and subtract 50 (the second year's returns), and then divide that by two (the number of years), you would say that the average return is 25%. That should mean Ian has about $156 after two years.
But the fact of the matter is, this math doesn't work with investing. Ian started with $100, and he ended with $100. He had a CAGR -- or average annual return -- of 0% per year.
Why this could be dangerous to your retirement planning
One could argue that even if Ramsey is wrong, he's getting people to save, which is good. That's fair, but I think it's also a blatant form of false hope, and sets people up for a cruel reality check as they get closer to retirement.
Let's take the case of a 25-year-old who is going to start saving today, and wants to retire when he's 65 with $1 million -- just as Ramsey mentioned on his Twitter page.
If that investor assumes he'll make a 12% return per year on his investments, he'll need to save $97 per month. If, however, he assumes his return will be 6.7% -- the S&P 500's CAGR while factoring in inflation, which Ramsey claims to do -- that number jumps to $422 per month.
Think about that: $97 per month versus $422. That's an enormous difference!
For the hapless investor who saved $97 per month but experienced a more-normal 6.7% return per year, he will be over $770,000 -- or 77% -- short of his investment goal.
I'm not sure why Ramsey harps on this 12% figure while not offering any solid numbers to back it up. His followers would be well served to dial down their assumptions before adjusting their retirement planning process.
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The article Dangerous Retirement Planning Advice From Financial Guru Dave Ramsey originally appeared on Fool.com.Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.