Dave Ramsey’s Investing Advice, Optimism And behavioural Finance

Dave Ramsey is a well-known author and media personality famous for his focus on saving and getting your financial house in order. His books have hit The New York Times’ bestseller list and 137,000 people follow his radio show’s Twitter feed.

Praise seems to be universal when it comes to his advice on how to pay down debt and save. But his ideas about investing are far less popular with some, who argue they are irresponsibly optimistic. Why does he set hopes so high? 

Ramsey’s projections on investing are quite optimistic.  He says investors can expect a lofty 12% annualized return on their investments. He also says they can plan to withdraw 8% of their savings each year in retirement. That’s twice the 4% benchmark that’s most commonly sited as the historically sustainable withdrawal rate.

Armed with such a rosy view, Ramsey has given the following remarkable example in his courses:
A 30-year-old couple making $48,000 and saving 15% per year, while  earning 12% a year on their portfolio would have more than $7 million saved by the age of 70.

$7 million!

It seems too-good-to-be-true on its very surface and that made me wonder why someone who seems to be such a successful motivator (who’s proven good at getting Americans — historically among worst savers on the planet — to stop borrowing and actually save) would chose to use such a far-out number.

There is a logic behind this super-sized projection according to behavioural finance expert and Santa Clara University Professor Meir Statman. “Making the reward for waiting larger helps us muster the self control necessary for delayed gratification,” Statman explains. “This is the purpose of the emphasis on the power of compounding.”

In his book “What Investors Really Want,” Statman uses the example of Lottery bonds, popular in the United Kingdom and other countries. The British bonds promise a return of principle and, instead of interest,  a shot at lottery wins as great at 1 million British pounds. One-quarter of British households hold some form of lottery bond, which come in denominations as low as a single British pound. According to Statman they are especially popular with people who find it hard to save.  “The vision of a big prize facilitates savings,” he explains.

In the 2007 paper “Optimism and economic choice,” Duke academics Manju Puri and David T. Robinson also found that optimists are better savers. According to their research, a “one-standard deviation shift in optimism increases the probability of savings by about 2%.”

The study looked at optimists’ work choices, tendency to remarry as well as their portfolio and investing moves. The authors determine that most of the evidence points to a  conclusion that “optimism drives economic choices.”

There is a downside to being excessively upbeat, Statman warns: “A promise of an overly optimistic prize can lead to unwise choices, whether that’s a promise of a $100 million prize for a $1 lottery ticket, or a promise of a 12% annual return which leads investors to portfolios that are too heavily skewed toward equities. Some lottery players win, and the market might reward us with long term returns of more than 12% per year. But this does not make such bets wise.”

Three of the most commonly voiced concerns about Ramsey’s investing advice are:

1. Ramsey advises putting all your investments into equities, no stocks, REITs or other investments and keeping that same allocation up until retirement. This goes against most conventional wisdom, including the rule of thumb espoused by Vanguard’s John Bogle and others that you own your age in bonds — so a 40-year-old would have a portfolio 40% bonds, 60% equities. A 70-year-old would hold 70% bonds, 30% equity. This strategy also contradicts the basic premise of one of the fastest-growing categories of mutual funds, Target Date Funds.  Target Dates are designed to have a “glide path” that gets more conservative (i.e., has less in equities) as you get toward your “target” retirement date. On Oblivious Investor, Mike Piper warns this level of equities “… would expose most retired (or soon-to-be-retired) investors to a meaningful risk of running out of money as a result of a poorly timed bear market.”

2. Ramsey asserts that investors can expect a 12% annual return from their investments. This idea raised enough eyebrows that a few weeks ago, Ramsey’s own blog posted an entry called “The 12% Reality.” It explains that the root of that 12% is the S&P 500′s average annual return from 1926 — the year of the S&P’s inception — through 2010: 11.84%. That seems to ignore both the cost of investing and inflation. But it also doesn’t address the huge gyrations that the index has gone through. In the decade of the 1950s, your return would have been even better than that 16.7% — bBut in the 1970s it was – 1.4%.

3. The idea that an investor can rely on pulling 8% a year out of their retirement seems chancy. That’s twice the speed of the most common 4% rule of thumb — and even that is something conservative types like Jim Otar, think is far too much. Otar’s argument is that a low withdrawal rate is your best defence against the market gyrations addressed above.

Optimism may be motivating, but has Dave Ramsey taken the power of positive thinking too far?

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