Dave Ramsey: In This Case, Fractally Wrong

So, you may have read a bit about Dave Ramsey before, either here or elsewhere.  Well, I just found this gem on his website.  I had to take a screenshot, just because I didn’t think you would believe me when I deconstructed his advice.  I’ve edited out extraneous junk (tags and such), but the context is all there.

Why Not Invest In S&P 500? from daveramsey.com

© 2011 Lampo Licensing, LLC, Reproduced under principle of Fair Use for the purposes of criticism and comment.

I would call Dave’s advice here not only wrong, but fractally wrong, in that, like a fractal, it is wrong at every scale.  Go find out more about fractals here.

Allow me to insert my commentary into Dave’s answer.  Dave’s response is in italic, my response is in blue.  I had to break up the response into paragraphs in order to avoid the dreaded wall ‘o text.

ANSWER: I recommend mutual funds because they always beat the S&P.

No, mutual funds don’t always beat the S&P 500 (aka “the market”).  As a matter of fact, many mutual funds frequently underperform the market.  This is partially due to the fact that most mutual funds have something called an expense ratio, which is a management fee.  It’s also partially due to there being a very large number of very smart people picking stocks and competing with each other, among other reasons.  This statement is so wrong it staggers the mind.

You can own several funds that beat the S&P whether in an up-market or a down-market.

Well, I suppose it’s possible… but it’s also very unlikely.  Remember, there are thousands upon thousands of funds available to invest in, but you have to be able to choose just a few. I, personally, can’t think of a particular fund that did well in both up and down markets.  But I do know of an investment manager that brought in above market returns with low volatility during both up and down markets:  Bernard Madoff.

It’s alright to own some SNP [WHAT!?!], but none of your retirement savings should be in that.

Should none of our retirement savings be in the “SNP” because it’s a transcription error?  Or, should none of our retirement savings be in the S&P 500?  Fun fact: no one could invest in the S&P 500, seeing as how it’s an index.  You could invest in a fund that is designed to closely track the S&P 500, but you can’t invest directly in an index.  Standard and Poor’s explain it on their S&P500 Fact Sheet.

Secondly, why in the world shouldn’t we have some retirement funds invested in a fund that tracks the S&P 500?  The S&P 500 is composed of the 500 largest stocks in the U.S.  It tracks companies like Wal-Mart Stores, Coca-Cola Co., Apple, Google Inc., and so on.  Do you know what many, many mutual funds invest in?  They invest in large, U.S. companies like Wal-Mart Stores, Coca-Cola Co., Apple, Google Inc. and so on.*  All I’m saying is that acting like funds that invest in the S&P 500 are some weird, high-risk  investment compared to other funds that invest heavily in the same type of underlying stocks is silly.

There’s another major difference between funds that invest solely in the S&P 500 and many other mutual funds.  The cost.  For example, a popular fund that seeks to replicate the S&P 500 Index is the Vanguard 500 Index Fund Investor Share, which has an expense ratio of 0.17%.**  That is the percent of your investment that goes to the management company as a fee.  According to investopedia.com, the average expense ratio for a large cap mutual fund is 1.45% So, which is bigger: 0.17% or 1.45%?  Yeah.

We can’t talk about fees without taking a moment to talk about loads.  When Mr. or Ms. Average Investor go to invest in a mutual fund, they will usually have to pay a “load,” which is a sales fee.  An extremely common type of load is the front-end load or Class A share.  For example, if you invest in American Funds Growth Fund of America A, then the highest load is 5.75%.***  So, you would put in, say, $1000 and then immediately lose 5.75% in a sales fee under the A share.  What’s the load on an index fund like, say, Vanguard 500 Index Fund Investor Share There is no load.

Now we’re starting to see a substantial difference between a mutual fund that actively manages its stock selection and investing in a mutual fund that passively invests in accordance to an index.  There’s more to it than that, of course, but not so much that warrants treating passive investing as dangerous to retirement savings.

Frankly, there’s no reason to ghettoize a S&P 500 index fund to the”fun money” investment account.  S&P 500 index funds have been used as part of a well diversified portfolio for retirement savings by advisors and investors all over the world.****

If you do a little bit of looking you can find tax-protected Roth IRAs and 401-Ks that give much better returns than the S&P.

Wow.  I can’t believe that someone who plays financial expert on the radio made this mistake.  This is like telling a Star Wars fan that your favorite character was Mr. Spock.*****  All a Star Wars fan can do after their spit-take is stare in shocked horror.  That’s what reading this sentence is like, as a financial planner.  It’s just a big ‘ol pile of stupid.

What’s scary is that he should know this stuff!  A Roth IRA or 401(k) is a type of account.  Comparing the type of account with an investment that is in the account makes no sense.  Imagine if they type of account is analogous to a bucket.  Like a filling a bucket with stuff, the account can hold investments.  Now, let’s read that sentence again, with a few substitutions: If you do a little bit of looking you can find ‘buckets’ that are better than ‘stuff in buckets.’  It doesn’t make sense, does it?  It’s comparing apples to oranges wildebeest.  It’s that different.

Also, it takes quite a bit of work and luck to beat the averages.  Frankly, I don’t appreciate the flippant attitude.  Judicious investing is harder than he’s making it out to be.

For example, take a mutual fund with a 25-year track record.  Over the course of those 25 years if you can see that the mutual fund almost always beats the S&P, then that mutual fund contains stocks that are winning more than the overall market is winning.

“Ok, cool!  Buy a fund with a long-term record of success and that means it will outperform in the future, right?  Man, this investing stuff is easy!”  I hate to be the bearer of reality/bad news, but that simply isn’t true.  As a matter of fact, the SEC says:

“This year’s top-performing mutual funds aren’t necessarily going to be next year’s best performers. It’s not uncommon for a fund to have better-than-average performance one year and mediocre or below-average performance the following year. That’s why the SEC requires funds to tell investors that a fund’s past performance does not necessarily predict future results. You can learn what factors to consider before investing in a mutual fund by reading Mutual Fund Investing: Look at More Than a Mutual Fund’s Past Performance.” [Emphasis mine]

Notice, the SEC didn’t say “Make sure your fund has a 25 year track record of excellence, that way you are assured better-than-market-returns!”  Because.  That’s.  Not.  How.  Investing.  Works.

Also, most funds that invest in large companies have something that’s called “turnover.”  It’s a metric of how much trading they’re doing in and out of various stocks.  Mutual funds turnover rates are published and easy to find.  Passive, index imitating funds tend to have very low turnover.  Actively managed funds that are seeking to beat the index tend to have higher turnover.  It is, in my opinion, highly likely that his 25-years-of-awesome fund has had significant turnover over its lifetime.  Reading the last sentence paints the picture that the grail fund has managed to outperform the index through superior stock buying and holding, while the stocks they chose “win” more than the market.  It’s, in my opinion, likely that the fund of legend and tale has outperformed due to frequent trading and market timing, or the genius of a particular portfolio manager.  All of that is hard to replicate.

And “win?”  Seriously, that’s gambling talk.  We don’t do that here.

Finally, please quit with the attitude of:  “Investing, so easy a cave man can do it!”  It’s really insulting to all the people like me who bust their hind ends to develop expertise in this field.  It’s like saying:  “Running a nuclear reactor: so easy Homer Simpson can do it!”  and being serious.  Nuclear engineers would resent it.  I resent it.  Quit it.

Well, we’ve toured the Mandelbrot set of failure that is this particular snippet of Dave Ramsey’s advice.  Not all of his advice is, in my opinion, unadulterated suck, but I saw this little piece of work and had to blog it.  (By the way, you should have seen Cindy’s face when I read it to her.  She was scandalized!)  Anyways, allow me to leave you with this nice little YouTube clip of zooming in to a Mandelbrot set.  I think you’ll enjoy spotting repetitions of the pattern at smaller and smaller scales.


*  There are so many types of mutual funds that it’s hard to paint with a broad brush.  One of the most popular styles of mutual funds is the Large Cap style, which invests primarily in stocks listed in the S&P 500 index.  In the interests of fairness, there are also many, many other mutual funds that don’t invest in the S&P 500.

**  As of today.

***  For more detail on fees, read the prospectus.  American Funds has, in my opinion, a very readable and friendly prospectus.  It’s a good place to cut your “prospectus teeth.”

****  As always, consult your investment professional before making any investments.

*****  Star Wars was the one with Luke Skywalker, Darth Vader and Yoda.  Star Trek was the one with Captain Kirk, Mr. Spock, and Dr. McCoy.

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