Dave Ramsey has become famous for a startling claim. He says stocks have returned an average of 12 percent over the long term. And he expects a 12 percent return over the long run going forward, too. On his website he dedicates at least two pages to his claim.
In one article, "The 12% Reality", we learn that Ramsey is "using a real number that's based on the historical average annual return of the S&P 500." The article claims that the "current average annual return from 1926, the year of the S&P's inception, through 2011 is 11.69 percent." In a second article, Ramsey declares you can find mutual funds with a track record of 12 percent returns for the past 70 years. Whether such funds, if they exist, will return 12 percent after fees in the next 70 years is another matter. Here's why shooting for 12 percent returns could cause you to make investment mistakes:
The calculation is misleading. The use of "average annual returns" for the S&P 500 has raised eyebrows because average annual returns are not what investors actually receive. For example, imagine investing $10,000 for two years. In year one the investment earns 100 percent, and in the second year it loses 50 percent. The average annual return over these two years is 25 percent. But the investment didn't earn a 25 percent return. It earned absolutely nothing. In the first year the 100 percent return took the balance to $20,000. In the second year the 50 percent loss brought it back down to its original $10,000.
So, while the S&P 500 produced an average return of 11.69 percent from 1926 to 2011, what investors actually earned was just shy of 10 percent. The average return does not account for volatility. As volatility increases, the gap between average returns and annualized returns widens.
Withdraw too much. Ramsey uses the average annual return of roughly 12 percent to justify an 8 percent withdrawal rate in retirement. However, numerous studies have calculated that a safer withdrawal rate is 4 percent to 5 percent for a typical 30-year retirement. Some people even argue that a 3 percent withdrawal rate is more accurate. Withdrawing 8 percent a year with the expectation of an overall 12 percent return will significantly increase the chances that your money runs out before you do.
Take on too much risk. Expecting a 12 percent return will leave many retirement savers disappointed. Investors may understandably become impatient when actual returns fall short of 12 percent. This can cause investors to change funds, advisors or both as they chase the elusive 12 percent return. It may also encourage investors to take on too much risk with a portfolio of 100 percent stocks.
High fees. Chasing 12 percent returns may result in portfolios that are exposed to heavy investment fees. Ramsey recommends the use of commission-based brokers, who often sell funds with front loads of 5 percent or more. Add to that funds with high expense ratios and transaction costs, and these fees can eat away at a substantial portion of an investor's returns. These high fees paid in pursuit of a 12 percent return may make such returns even less likely to ever materialize.
Ramsey is an incredibly popular personal finance figure. He has helped thousands of individuals and families pull themselves out of debt. He helped inspire me at age 40 to get out of debt. Because his influence is so strong when it comes to getting out of debt, it stands to reason that many people will follow his investing advice, too. For those who do, you may want to ratchet down Ramsey 's enthusiasm about future market returns.
Rob Berger is an attorney and founder of the popular personal finance and investing blog, doughroller.net. He is also the editor of the Dough Roller Weekly Newsletter, a free newsletter covering all aspects of personal finance and investing, and the Dough Roller Money Podcast.
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