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Dave Ramsey's Financial Planning Boo-boos

By Stephen Nelson

Republish: EasyPublish™ Published: 06Nov2009 Word count: 752 Viewed: 672 time(s) Get Free Content For Your Site

Before this author identifies a handful of financial planning errors that best-selling author Dave Ramsey regularly makes, one or two comments should be made. First, Dave Ramsey's general advice to work hard, make your marriage a priority and avoid debt is excellent. In fact, no one who followed Ramsey's general philosophy would have gotten into serious trouble with a subprime mortgage in the recent financial crisis. And, a second important comment and commendation for Mr. Ramsey: Perhaps 95% or 99% percent of what Dave says, every knowledgeable financial planning expert will agree with. Dave Ramsey is one of the good guys.

Nevertheless, in a handful of specific areas, one can find some minor yet important faults with the financial planning advice that Ramsey gives--and in particular with the financial calculations Dave shares in, for example, his books.

Overly Optimistic Rate of Return Assumption

One of the first problems that appear to certified public accountants and chartered financial analysts looking at Ramsey's materials concerns the commonly quoted "12%" rate of return used in examples.

That's way too optimistic an assumption. Yes, sometimes investments will return 12%. And some specialty categories of investments (like small company stocks) may return roughly 12% over lengthy periods of time. But a traditional portfolio of diversified stocks and bonds will probably over long financial planning horizons deliver average annual returns of more like 7%-9%.

You will not, sadly, find it possible to consistently earn 12% on a well-diversified, moderate-risk investment portfolio. No way.

Inflation Ignored Only Leads to Future Disappointments

Inflation represents another issue that an accountant or good financial planner will want to include in financial plans but an issue that isn't always thoroughly discussed by Dave. Inflation can be tricky to incorporate. But inflation will probably eat away at the value of the savings you accumulate.

If you're earning 9% on your investments, for example, but inflation runs 3%, you're not really making 9%. You're making 6%. You can more implicitly recognize inflation in your financial planning calculations, by the way, by using the net-of-inflation return in your financial calculations. In other words, to adjust for the inflation issue in the case where you expect a 9% return and 3% inflation, do your calculations using a 6% "real" return.

Expense Ratios Matter

One final investment issue (for some investors) needs to be highlighted. While investment expense ratios often don't matter much for people just starting to save money--probably this is Ramsey's typical reader in fairness--by the time one accumulates a more size-able investment nest egg, investment costs matter. And they matter a whole lot.

In fact, if an investment pays a 2% expense ratio--and that sort of expense might be pretty normal once all the investment costs are tallied--that amount doesn't sound so bad. But it's pretty outrageous in most circumstances.

Consider the case, for example, where you've got a 9% investment and 3% inflation. In actuality, you're really only earning 6% on your money. (The inflation that's baked into the return is not really profit to you.)

If out of your net 6% investment return, you pay 2% in investment fees--in other words, if you pay out 2/6ths of your profit for investment expenses--that's equivalent to a 33% income tax. Ouch.

In the end--just to play this sad song to the very end--while you start with 9%, after you subtract 3% inflation and 2% in investment fees--you're left with only 4%. And note that value is a pre-tax return. So if you pay income taxes on your investment profits (and you probably will eventually), you'll actually end up with something less than 4%. Double ouch.

Putting These Financial Planning Insights Together

The nit-picking shared in the preceding paragraphs may seem a little unfair. But to show how significant they become, especially in combination, consider these two calculations:

If you and your spouse save $5,000 a year into a retirement fund for 30 years and say you'll earn 12% annually, the calculated future value equals roughly $1,200,000.

Note: If you have access to a computer with Microsoft Excel, you can copy this formula into a spreadsheet cell to test this assertion: =FV(0.12,30,-5000)

In comparison, if you and your spouse save the same $5,000 a year in an IRA or 401(k) plan for 30 years but admit (sheepishly) that you'll really only earn 4% once you adjust for inflation and that friendly financial advisor, the calculated future value equals roughly $280,000.

Note: Again, if you have access to a personal computer and Microsoft Excel, you can copy this formula into a spreadsheet cell to test my math: =FV(0.04,30,-5000)

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