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Dave Ramsey scares me

Dave had published his expectations that the market would grow 12% on average and right until 2000 there was little reason to dispute this. Only, there was something wrong with Dave’s math even then. There’s a difference between the long term CAGR (compound annual growth rate) and the average return. Let me explain. If in one year, the market is up 20% and the next year it’s down 10%, you’d be inclined to add (-10+20)= 10, then divide by 2, for a 5%/yr average return, right? But, the way to calculate the CAGR is to take the returns, and multiply, 1.2*.9= 1.08. this is over 2 years, so you take the nth root, in this case 2, and get 3.92% per year. This may seem a minor difference, but it accumulates over time, and down years of say 33%, take a 50% increase to overcome.

Let’s look at the danger of relying on this magic 12%/yr number. First, if you wish to tinker for yourself, I wrote a small spreadsheet you can download to your computer. I start with the premise that (a) we shouldn’t count on Social Security, if it’s there in 30 years, treat it as a bonus. I also believe that 4% is the safe rate of withdrawal from your retirement account. This multiplies up to a requirement to have about twenty times your preretirement income saved as a lump sum, so you can withdraw 80% of your final income each year. Last I use 43 years of work, from age 21 to 63. When assuming a conservative 8% return per year, we find that we need to save 15% of our gross income. Not too crazy if you are dedicated to keeping your spending under control.

Now, if we run the numbers that Dave suggests, a 12% per year return tell you that you only need to save 5% per year. Wow, you think, I can really afford that, but 15% is crazy. You then find that after a decade like we just had, the compound return was a negative 1% per year. You see that by investing only 5%, you saved up about 42% (after losses) of your current income, and even if the market gets back on track, you still find you have only 15 times your final income. If the market return is a lower 8%, you retire with only six times your income, enough to withdraw less than a quarter of what you lived on prior.

On the flip side, by saving 15% as I suggest, even after this bad decade, an 8% return for the remaining time will put you at just under 18 times your final income, just a 10% shortfall. The reason Dave scares me is that even in my most optimistic days, I never assumed a 12% return long term. Not long ago, I wrote an article titled A Change of Plans, in which I looked at the S&P chart from 1980 through 2000 and extrapolate where it should have been 10 years later, in 2010:  3600, 4 times the value it actually was in 2010. Admittedly, I didn’t expect an entire decade to produce a loss, nor did I expect, as Dave did, to see 210% gains.

I’m curious what Dave’s followers did over the last ten years, have your expectations changed? Dave has only dug his heals in further, recently writing The 12% Reality. Sorry, I call it the 12% pipedream. Let me close with one question – would you rather plan for 8% and when returns are actually 12% or higher, find you can retire at 45 or 50, or would you plan for 12% and if the market stumbles even a bit, have to work till you are 70?


  • Robert Muir May 31, 2011, 10:07 am

    I’ve always assumed, (yes I know what that means), and I’m probably wrong, that Dave knows the 12% figure is way too high, but by using it, he thinks he has a better chance of convincing his listeners to invest. Keep in mind that the vast majority of his listeners are or were in debt their whole lives. If they’ve ever invested at all, it was the minimum match in their 401k.

    So he gets them fired up to become gazelle intense and get out of debt. What then? By keeping the investment strategy simple and inflating the numbers a bit, maybe he can convince middle-aged “normal” folk to open some mutual funds begin investing rather than merely saving.

  • Bill May 31, 2011, 10:36 am

    I think Dave is an optimist but he recommends people save 15% for retirement and live debt free. You really think this is bad advice, because he is over optimistic on stock returns you should not save at least 15%?

    If you take 500 people that do as Dave teaches: dept free + 15% to retirement verses 500 people that are in debt up to their eye balls and no retirement saving because no one can get 12% over the long term!!

    Which group do you think will be in better shape financially at retirement?

  • Darren May 31, 2011, 11:43 am

    From the books I read, 8 percent seems like a more realistic number.

    Twelve percent may be possible, if you start very early and invest heavily in stocks over the long term. But many don’t follow this route.

    And although I’ve also heard of the 4 percent safe withdrawal rate, I’ve read that if you can cut it to 3.5 percent, your money will last much longer.

  • Augustine May 31, 2011, 1:50 pm

    Assuming 8% and ignoring inflation is scary too.

  • JOE May 31, 2011, 2:05 pm

    Bill, Dave’s article I linked to didn’t show any suggested saving rate. If he recommends 15%, that 12% rate of return will show an enormous retirement balance by age 62. I think anyone that looks at a spreadsheet will think the 15% is too much and will save less. Maybe he counts on his followers to not go that far, not bother with any math?

  • gef05 May 31, 2011, 6:19 pm


    “but he recommends people save 15% for retirement and live debt free. You really think this is bad advice, because he is over optimistic on stock returns you should not save at least 15%?”

    No, that’s not bad advice, it’s reasonable and safe.

    What is bad is that he wraps advice like that in rhetoric and nothing more. his article offers nothing – nothing – beyond a feel good sell.

    “And the past shows us that each 10-year period of low returns has been followed by a 10-year period of excellent returns, ranging from 13% to 18%!”

    This isn’t evidence. It isn’t actionable. It’s history. And I pity the investor who can’t tell the difference.

  • JOE May 31, 2011, 10:54 pm

    @ Augustine – my longterm plan, the spreadsheet I referenced and linked to, accounts for inflation. Since it tracks savings as a ratio of one’s annual income, the final number prior to retirement is targeted to replace your final income, not your starting income. If your salary outpaces inflation, this would track as if you spend a consistent portion of that income. Of course, life isn’t linear. I’ve gotten comments that the sheet should offer higher income increases early on, and level to the inflation rate later in one’s career. It seemed simpler to just advise the user to enter numbers as they earn their salary. The rate of return certainly won’t be the same 8% each year, but hopefully, the average will meet or exceed this.

  • Elle June 1, 2011, 11:34 pm

    I see that moneychimp.com’s calculator presents both Dave’s way (the “average” return) and true CAGR.

    I think the “average” return is probably not a Dave-ism but instead phony baloney that many use.

    CAGR is the way to go.

  • Nancy Jean July 12, 2011, 8:45 pm

    Dave Ramsey and his wife paid a high price to defeat debt. God has truly anointed these two vessels for His people to walk in financial freedom.
    No one is perfect, but do what does work and if you have something that others can learn from, share that and not slander each other. Love covers a multiude of sin…..but one man’s wrong can destroy a generation.
    Debt-free in Texas

  • JOE July 14, 2011, 9:51 am

    Dave is a great motivator for debt elimination. I agree there. His investment advice, specifically his predictions for market returns, is destructive, I wonder how his followers did during the last decade. No reasonable person, expert or not, has a 12%/yr expectation. This prediction actually encourages people to save too little.

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