Dave Ramsey

I have noticed to my chagrin the growing popularity of Dave Ramsey in the past few years. While no doubt helped along by the housing crisis and following rise in unemployment, many people have endorsed his program with a zeal approaching that of Jim Jones' followers. I would like to consider myself fairly savvy in personal finance matters so I began to look into his program after being accosted on numerous occasions by his rabid fans. Upon closer inspection, his program is really about instilling discipline in people with none to speak of and certainly not about making optimal financial decisions. In short, his steps are out of order, wrong, or have fairly significant opportunity costs associated with them. Since it is Sunday, this is a good opportunity to discuss a guy who makes millions selling problematic advice to people based on religious commonality.

This example will (hopefully) underscore the points above. One of his mantras is the evil of credit cards, in his view they are so terrible that they shouldn’t be used even if you pay the balance off in its entirety every month. His premise here is that the use of credit cards encourages people to spend more than if they used cash. While research shows this to be true among some individuals, it’s certainly not a universal truth. More about this universal truth thing later, but Dave Ramsey's use of statistics and inability to form a logical argument through the use of actual facts are somewhat distracting to a discriminating reader. So let’s say you’re a person with some modicum of self discipline, if you used cash instead of credit cards you are subsidizing the purchasers who do use credit cards, like me. A retailer has to pay an interchange fee for every credit card purchase, but since he cannot price discriminate among buyers based on form of payment, these costs get passed along to all consumers in the form of higher prices. Operating in this manner also allows you to keep significantly more of your liquid capital in higher yielding savings accounts rather than cash which has a negative yield (inflation). While recent legislative initiatives may eventually free retailers to pursue price discrimination, until then, Dave is costing you money.

There’s another issue, investing, on which I believe Dave Ramsey’s advice is actually more harmful than helpful due to his lack of subject matter expertise. The root cause is his fundamental aversion to math and the degree to which his methods rely on behaviors for which no objective analysis exists. For instance on ETFs, “I do not own ETFs and do not recommend them as part of your investment plan. ETFs are baskets of single stocks that intend to operate like mutual funds; but they are not mutual funds.” This is an unclear, if not erroneous, statement. Mutual funds are also baskets of single stocks in that they own numerous individual equities so what is his point? The problem is that Dave does not understand what most ETFs are and why in many cases they are actually more beneficial than owning a mutual fund with a similar strategy to that of the ETF. Most ETFs track established indices and do so with less tracking error and at a lower cost than a traditional index mutual fund. The downside is that you must pay commission costs for each trade which a no-load index fund wouldn’t charge. Generally speaking, the higher the dollar amount of each individual transaction, the more beneficial an ETF is.

But the most egregious advice that Dave proffers is to invest “25% into each of these four types of funds: growth, growth & income, aggressive growth, and international.” He goes on to mention the criteria for selection: front end load, funds at least 5 years old or older, and solid track record of acceptable returns within fund category. First and foremost, Dave should know his audience. There are some relatively smart people (Fama and French come to mind) that have made careers out of showing the inability of experienced investment professionals to beat the market. Dave’s followers don’t rise to that level of expertise and if they are unsophisticated enough to use his other strategies, they should be investing through indices. The mutual funds that they choose will likely not beat the market index over time and the costs (Dave may be the only person still recommending load funds) will further exacerbate the difference. Furthermore, the four categories listed above (growth…) are not asset categories and his recommended strategy is anything but diversified. Diversification is achieved through investing across different asset classes, industries, geographic areas, and company sizes. The picture above shows the returns of different asset classes over previous years. One thing to note, Dave says “As a category, REITs just don’t stack up to good growth stock mutual funds. I do not own any REITs and don’t suggest them for you. If you really want to invest in REITs, limit them to no more than 10% of your local investment portfolio.” Check out the column on the far right, this shows the annualized returns of different asset classes from 1999 to 2009 (as of 12/31/2009 from Bloomberg). You’ll notice that the top performing asset class is Gold at + 14.3%, followed by REITs at + 10.6%. Way down at the bottom of the list is U.S. Growth at -4.0%. Following Dave's advice results in lowered (if not negative) returns and significant opportunity costs.

Finally, the central theme of his strategy, the debt-snowball. From his website, “the math seems to lean toward paying the highest interest debts first, but ….” The math doesn’t “lean,” it unequivocally supports the notion that you should pay down the highest interest debt first. If you choose another payment strategy it should have some sort of actual financial basis, i.e. terms on the debt (it is variable and the rate will soon adjust), your relationship to the lender (family members are terrible lenders), or the underlying asset. Otherwise, you are paying a significant premium, the spread between the rate on your smallest debt and that of your highest debt interest rate, for supposed momentum. The debt snowball is a judgment call on the psyche of his listeners. Without some sort of empirical analysis, it’s impossible to say whether this is any more likely to encourage repayment of debt than the far more rational notion of attacking the highest interest rate first. My assumption would be that this momentum doesn’t actually result in significantly higher success rates.

If there’s an overarching theme to personal finance, it is that it pays to seek good advice. The opportunity cost of using someone because they espouse your religious beliefs, their books look cool, they don't charge explicit fees, or their CNBC show is some sort of financial voyeurism is far too high. My recommendation is to go find your nearest fee-only CFP. You are paying Dave for advice that’s costing you more than you’re saving.

May 26 update: Dave Ramsey recommends you use what are called ELPs (endorsed local providers). He does this because they pay him a fee for referrals and are granted exclusive geographic areas to service. These are not the best finacial advisors and in fact, most are not certified finanical planners. A financial planner worth his salt doesn't engage in this type of behavior and a legitmate one would steer you away from the type of investments Dave recommends. If you use an ELP, you're getting set up. In return for not making the same return that someone in a lower cost index fund does, your finanical planner gets a commision from the mutual fund, part of which he then kicks back to Dave. If that sounds shady, well it is. That's why you don't find the details of this arrangment in every location where he recommends the service of an ELP.