Last week, a former classmate shared a Dave Ramsey article about early savings. Ramsey stated a teenager could save a couple thousand a year, stop saving in their 20s, and still retire a multimillionaire. I agree with the sentiment completely, but I’m concerned that Ramsey overstates how rich that person can expect to become.
Ramsey’s favored investment vehicle is a mutual fund that tracks the S&P 500.
The problem with the article is that he assumed an annual return on investment of 12 percent, which is well above every reasonable historical estimate I’ve ever heard of S&P 500 rates of return. Forbes agrees. Ramsey is basing his number on a subset of history, not all available history.
The other problem, besides Ramsey using the wrong number, is that he’s rounding up the wrong number–rounding 11.89 percent to 12. And when you’re compounding, you compound the error. When you read the article, Ramsey admits the 11.89 percent figure in the text, but his charts use the rounded percentage.
When you’re planning finances, round off against your advantage. If your rate of return is 11.89, round it down to 11. If inflation is 2.1 percent, round it up to 3. That gives your numbers a hedge against the unexpected. You might still do worse than you planned, but it decreases the odds of that happening.
If you need to get better than 10 percent, I’ve written about that before. I won’t promise that my way will get you 12 percent, but it will get you more than Dave Ramsey’s strategy gets you, and it still won’t cost you any more.
What Ramsey isn’t telling you is that his S&P 500 returns are an average. Some years you’ll make more than you expected. Some years you’ll make less, or even lose. In the years that large companies are struggling, smaller companies might be profitable investments. Or maybe offshore companies will. Smart investors don’t tie their fate to one specific type of investment. That’s why the executives of successful companies sell some of their own company stock every year–they believe in their company, hopefully, but they need more diversification in case something unexpected happens.
With Dave Ramsey’s way, the ebbs and flows of the market will help you in some years and hurt you in others. With my way, the ebbs and flows of the market usually help you, and in the years when they hurt you, you’ll recover more quickly.
I’ve defended Ramsey in the past, and while I do think you’re better off following Ramsey’s advice than you are doing nothing, it bothers me that he would be this intentionally misleading. Because overall, he’s right. I can tell you that from my own experience. When I was a teenager, I saved more than 75% of they money I made. By the time I was 17, I was investing in a mutual fund.
I continued those habits into my 20s, and that meant I bought a house much sooner than most of my peers did, and around the time they had enough to make a down payment on their first house, my wife and I were paying off the mortgage on that house.
Maybe he thinks people won’t save unless that number at the end is bigger. That’s unfortunate.