In researching the first post on Dave Ramsey, I came across a score of blogs devoted to propagating the erroneous investing/debt reduction theories he espouses. Most of the blog writers (biblemoneymatters.com or the Christiandollar.com) share his foibles, generally ignoring math and statistics and stating incorrect return data or advice so poor it seems negligent. The statements that are most irritating are those dealing with historic returns. Since he is a multi-millionaire and NY Times bestseller, my intuition tells me that most people believe the numbers he throws out. So let’s set the record straight.
First, when considering the historical returns of any asset, use inflation adjusted figures. The purchasing power of a dollar erodes over time, you clearly cannot buy with the same dollar in the future an amount of goods equal to what you can today. The inflation rate is based on the Consumer Price Index, and while there are some disagreements over the content of the basket of goods that the CPI tracks as well as the way it is calculated, it is generally accurate. Interestingly enough, CPI or inflation is up 126% since the month I was born. This doesn’t mean that everything is 126% more expensive, just that the whole basket is.
Second, historical returns should be calculated using the compound annual growth rate (CAGR), not average annual returns. Averages tell you what to expect, +/- some standard deviation, in any given year. But when you invest, you don’t pick a random year - you invest in yr 1 and withdraw any number of years later. What matters then is how the value of that dollar rose in the time you had invested. CAGR is the annualized rate your investment would have grown if there were a standard deviation of 0%, which is what Dave Ramsey and his ilk would like you to believe average annual rates are. Imagine that you can invest for 10 yrs, the first 9 of those the return will be + 9% and in the last year, -20%. The average annual return is 6.1%, but the value of your $1 is now $1.73 rather than the $1.80 that the average annual return suggests. You can google CAGR if you wish, but broadly speaking, average annual returns ignore the standard deviation of expected returns and give you incredibly inflated numbers.
All that brings us to what return we should use in our long-term planning. The S&P 500 has a CAGR of 6.68% from 1871 to 2009 with standard deviation of 18.83%. The ending point here clearly has an effect on the data, but bottom line, expect 6-8% and around 20% standard deviation. That’s significantly lower than what you see Dave Ramsey preach. Why he says 12% I can’t say. It may be that he doesn’t understand inflation or CAGR, he believes it will make you feel better about investing or that it will makes the other steps of his plan make more sense. Whatever the case, he's wrong and this error is fatal to the rest of his investing advice.
Finally, historical returns on real estate are not great when compared to other asset classes. Robert Shiller, an economist at Yale, has analyzed historical residential returns and found them to outstrip inflation by roughly 3% per year. So when Dave suggests you invest in real estate or pay down your home mortgage, you’d be better off investing in a bond index which would achieve higher returns with less risk. This, in a nutshell, is my argument about why if you have a cheap fixed rate mortgage (anything under 6%), you should never pay it off early. All that money you used to pay it off could have been invested in something with a higher return and less risk (both systematic and idiosyncratic) like municipal bonds or corporate debt. In return for paying off your mortgage, you now have an investment vehicle which returns less than a risk free asset and is exposed to all sorts of risk (especially idiosyncratic).
Note: systematic risk – the risk that the entire country’s residential real estate market falls. Idiosyncratic risk – you bought a house next to the future interstate expansion, put a hot tub in the living room, and painted the rooms that god-awful color scheme.
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