May 18

The David (as I fondly call the entertainer Dave Ramsey) is known for his hyperbole. And his “my way or the highway” view on all things financial. One of his more memorable quotes is “No one ever says they got rich off of credit card points.” It seems to me that if I say so, and offer some supporting evidence, then he’s wrong. If he ever repeats himself, you can reply and tell him you know a guy that did. Let’s start here.

Screen shot 2015-05-02 at 3.28.43 PM

Above is a snapshot of my 529 account funded solely with the 2% cash back from my credit card. We use a credit card that offers 2% cash back on all purchases, and have had the card for nearly 16 years. It’s invested in an S&P index, so the number above includes the growth of the market. We have 2 years till my daughter goes off to college. Or 6 until her senior year. I’m hoping this account can grow to $40K and cover a full semester’s cost. That will make another topic for an article here.

In 2012, I wrote a guest post How I Made $4,000+ on a Cash Back Credit Card Offer. The exact number was $4550. That was a one time opportunity, for me, a way to take advantage of the institution we all hate, the bank that pays you .01% on you money, but charges you 5% on your mortgage, and a fee for every little thing. You can read all about it at the linked article.

Last, I’ve also had an Amex card that averaged over $500/yr in rebates for Costco and gas purchases, so another $10K on top of this. This all totals $40K, give or take.

There’s a site Global Rich List that puts wealth and income into perspective. I put in $40,000 and found

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If instead of wealth, we look at income, how about I look at the $1600/yr I can withdraw from the $40,000, and add $2000/yr, the amount I’ve been getting back in rewards, so $3600/yr.

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I offer this a bit tongue in cheek, as I know that $40,000 isn’t really rich, nor is $3600/yr living the dream. But $40,000 is still a chunk of change. If you look at how much we’ve saved for retirement in the US –

retirement-savings-by-age-group

That $40,000 is more than 40% of those nearing retirement have saved. Did I really get rich on credit card points? We can debate that. But first, ask the 31% of 55 year olds who have less than $10,000 saved if an extra $40,000 would make them feel rich, and then decide.

written by Joe \\ tags: ,

Oct 01

If you have a teenager in the house, you’re likely to hear the expression,”that’s the stupidest thing I’ve heard in my life.” A few things come to mind, “I guess you haven’t listened to some of the people I worked with,” is one, but I can’t keep from saying,”make a list and see if the next stupid thing you hear actually tops it, and so on.”

When it comes to the mistakes investors make, I’m sure the list is long. It probably starts with spending more than you make which results in simply not saving at all. Then comes not saving nearly enough because most people don’t actually go through the exercise of calculating their retirement needs. For those actually investing, a major error is the propensity to buy high and sell low. I wrote about this in Disappointing Returns sometime ago and described how for the 20 years ended Dec. 31, 2006, the average stock fund investor earned a paltry 4.3 average annual compounded return compared to 11.8 percent for the Standard & Poor’s 500 index.

More recently, we discussed Frontline’s The Retirement Gamble, a PBS broadcast that focused on cost, how a 2% fee in one’s 401(k) would wipe out nearly 2/3 of your returns over time. If you use an advisor and find that his (or her) personal advice is worth a fee, that’s a different story. I’m strictly talking about ETF or mutual fund expenses. That said, I present you with the stupidest thing I’ve heard a financial author say. Ever. This may change, of course, but it’s the benchmark against which I’ll hold other foolish quotes I find for the rest of my life.

davidfees

This is from David Ramsey’s Financial Peace Revisited. And I’m a bit taken aback. There are two implications here. First, that there’s a positive correlation between expenses and returns, as if to say “you get what you pay for.” This was disproved years if not decades ago. The second, and even more dangerous implication is that 16% is a number that one can ever see long term. The 80’s and 90’s (remember those years?) brought us a whopping true compound return of 17.99%/yr. But, of course the next decade’s fiasco brought the 3 decade average down to 11.29%. A look further back brings us closer to an even 10% CAGR. 10%. Not 12%. And certainly not 16%. Consider, at 16%, investments double in 4.5 years. 45 years would result in 10 doubles or your investment growing 1000 fold. Imagine putting $1000 away each year for your 10 year old knowing that starting at 55, she’d be able to withdraw $1,000,000 each year. Sorry, not going to happen. And when it comes to finance, hyperbole has no place in the discussion.

Sorry, Dave, expenses matter, .5% per year over one’s investing lifetime adds up to a sizable fraction of their account. Hopefully, you’ll have the patience to understand this and withdraw these remarks that can damage your followers’ hard earned savings.

written by Joe \\ tags: ,

Apr 16

Every so often, it’s time to look at the terms that we use when discussing financial matters. I’d like to take a look at the terms ‘Average Return’ vs ‘Compound Annual Growth.’ These two phrases sound similar, yet the results can be quite different.

The math isn’t complex, so we’ll start with a simple example. Two years, the first year is up 20%, the second, down 20%. It’s pretty obvious that the average of +20 and -20 is zero, no surprise there. But the compound annual return is a bit different, as 1.2 * .8 = .96 and this results in -4% over a 2 year period or a true return of -2%/yr CAGR. I know that too many numbers make your eyes glaze over, so an image:

CAGR

This comes from the site Money Chimp, where you can check the market return between the end of two years, and adjust for inflation if you wish. It’s one thing to see random numbers trying to illustrate a point, and quite another to see how it would actually impact your money using real data. You can see that the Compound Annual Growth of “True CAGR” as the Chimp calls it, lags the Average by a full 2%. This is a result of the volatility of returns, as in my exaggerated example, a -20 cannot simply be averaged with a +20.

I don’t know what the market will do in the future. No one can know, really. But I do know how to look at the past, and to look at this specific period, 1926-2011, and suggest it returned 12% is simply incorrect. Had we actually seen 85 years of 11.84%, the result would have been a $13,513 return, four times the final return. Lest you think that the difference of 2% was a result of the 85 year time horizon shown, head over to the site and just enter 2001 and 2010 as the beginning and final years. You’ll learn the disparity is formed by both volatility as well as time, so even short periods are affected.

I was recently reminded of Dave Ramsey’s 12% ongoing market claim, and re-read his article The 12% Reality. In his article Dave confuses simple with compound average and stands his ground. He even discusses the so called Lost Decade; From 2000–2009, the market endured a major terrorist attack and a recession. S&P 500 reflected those tough times with an average annual return of 1%. Last I checked, ten years of 1% returns would grow your money at least 10%, no? The calculator shows us a True CAGR of -.99% for a cumulative loss of 9% over the decade. Let me spell that out – You started the decade with $10,000, and ended with $9,100, a bit less after expenses. Dave’s claim that you’d have $11,000 or so misses the true number by 20% for the decade.

I’ve always loved math, and find that it’s tough to argue with facts. Next time someone starts quoting market returns, remember, knowledge is power, and you’re now armed with the knowledge to help you understand the numbers and educate others.

written by Joe \\ tags: , , , ,

Jun 07

A week ago I wrote Dave Ramsey Scares me, for the fact that he forecasts the US stock market to grow at 12% as far as the eye can see and I think his disciples are ill-served by such prognostications. Over the past week, I thought some more on this. This is the same guy that talks about being debt free, paying the mortgage off as though it were a deal with devil. But wait a second, Dave, if I can borrow at 5% but get a 12% return on my money, why not just let that mortgage be, and start investing sooner? Let’s see what would happen if we did that.

I tried to keep the numbers simple here. A 5% mortgage even though rates are actually lower right now. A $250,000 starting balance. Simple means I ignore the mortgage tax deduction, I don’t need it to prove the point. If we do the math, we find the difference in payments between the 15 year and the 30 year terms to be just under $635. If you go with the 30 year mortgage, you’ll still have a balance after 15 years of $169,709.77. This is simply the nature of mortgages, the balance is not linear, it can’t be. The interesting thing is that if you invest that $635 and get an annual return of 5%, after 15 years you’d have exactly $169,709.77, the exact amount remaining on the mortgage. Dave however, believes 12% is the norm, so let’s skip right to that line on the chart. At 12%, you have over $317,000 in your account. This isn’t just more than the remaining mortgage balance, it’s so much greater that if you withdraw just the amount due on the mortgage, it’s still growing faster than the withdrawals. Of course, 12% per year is 1% per month, and 1% of this balance is $3,170 against a payment due of $1342.05. (Note – I also showed the account balance if the market only does 6,8, or 10% vs Dave’s 12. Still, some impressive numbers.)

I know there’s a reason Dave doesn’t recommend this approach, I just don’t know what it is. I continued to do the math, no more money out of your checking account to pay this mortgage, it all comes from the saving that $634. After another 15 years, you’d have just over $1.2 million sacked away. I’d really like to know the flip side of this, how one can reconcile a 12%/yr forecast and the maniacal payback of this low interest debt.

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May 31

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?

 

written by Joe \\ tags: , , ,