Friday, March 18, 2011

Dave Ramsey's investment assumptions

I am a fan of Dave Ramsey for the following reasons. He helped motivated us to pay off our unsecured debt (we used his snowball method to pay off $55,500 in unsecured debt in 12 and 1/2 months). I generally agree with him that personal finances is 80% emotion. I think his plan is easy to understand and fully support the idea and the practice of living a debt free life. Freedom from debt is freedom.

I catch Dave's show now and again on my way home from work. Recently he was talking about investing, why he preaches investing in the stock market and he touched on his assumption, which he relies on again and again in his books and on his show, that the stock market returns 12%. I've never believed the 12% number, and it has always been one of those things about Dave that I've thought undermined his overall message.

I thought, while listening to the show, that Dave was going to cling to the 12% number, but he recognized that people have challenged him on that number and as a result he ran his scenario using 8% and 10% returns as well.

This week when reading Dave's monthly newsletter, he again addressed the 12% return assumption. His newsletter sets forth where he gets his numbers from and based on my own independent research he is right. The S&P 500 from 1926 to December 31, 2010 returned, on average, 11.95% (not adjusted for inflation). And he is right that the S&P 500 during 1991-2010 returned, on average, 11.04% (again not adjusted for inflation).

But, most individual investors only obtain about 50% of the average returns. Which I think is why many other gurus and experts often suggest only assuming a 6% return when running the numbers in a retirement calculator. Why the discrepancy between average and individual return? Individual investors are very bad at timing the market. We, in general, pull our money out of the market when it goes down and put it back in when the market is going up. Said another way, we buy high and sell low.

So how do we combat this problem?

While I agree with Dave that 80% of personal finances is emotion, when it comes to investing emotion may be the problem. When faced with a volatile market you can do nothing. Doing nothing can be your plan. I speak from experience, in 2008 and 2009, we did not sell our 401k or IRA investments. And it was hard to watch our numbers go down, down, down, but it is important to remember that loss (and profit) is not locked in until you sell. We had enough time to wait it out, so we did nothing and almost all of our pre-2008 investments have fully recovered and gained.

Have a plan when you buy. This is something we are working on. When you buy a particular product, have a plan for when you will sell. Do you revisit the product every 5 years, every 10 years, depending on your age. Or do you revisit the product after the investment has doubled or tripled in value? Or do you do both? When we bought stock in 2009 the market was low, so since then, some of our investments have doubled and tripled in value. As such, we are looking at these investments and evaluating whether it makes sense to sell or to hold.

Have a global plan. If you are diversified, if you re-allocate your assets each year, you shouldn't have to sell in a down market.

Think before you trade. In general, the more an individual investor trades the worse their returns (over time). This truism means that Mr. Sam's trading experiment is eventually going to lose money.

1 comment:

Anonymous said...

While Dave Ramsey does wonders to help people get out of debt, he exaggerates market returns and dividend returns. You are correct, buying and selling always decreases returns because one misses days in market and pays more taxes. But management fees and expense ratios are just as big a reason for decreased returns. Passively managed index funds where a manager is not actively turning over funds (more taxes) thus allowing lower expense ratios is the most proven method of cosistently replicating market returns.