Dave Ramsey is a popular personal finance personality, and he’s got some great advice about paying back debt. But his advice about retirement planning leaves a lot to be desired.
Specifically, there are three ways Ramsey is steering his readers and listeners wrong about preparing for their later years. And the advice he gives on these issues could be costly and damaging. Here are the three worst pieces of retirement advice he gives.
1. You should choose mutual funds over ETFs or stocks
Ramsey recommends mutual funds over exchange-traded funds (ETFs) because:
- Mutual funds are designed to be invested in over the long term
- It’s possible to outperform the market by selecting the right mutual funds
- ETFs come with costs, and while the fees are usually lower than mutual funds, ETFs don’t offer the professional management mutual funds do
But here’s the problem.
ETFs can also be invested in for the long term. While you have the option of trading them like stocks, you don’t have to – you can keep them in your portfolio for decades. And there are a huge number of different ETFs, many of which also give you the chance to try to outperform the market.
You don’t have to invest in an ETF that just tracks the S&P 500 – you can choose a growth ETF, a dividend ETF, or even ETFs that track specific industries or sectors such as the marijuana industry or the healthcare industry.
So, mutual funds don’t actually have these two advantages over ETFs. Ramsey’s right about one thing, though – mutual funds do typically cost more than ETFs do. These extra fees can really add up when saving over many decades for retirement, and there’s little reason to pay them. Over time, history has shown that passively managed funds tend to outperform actively managed ones, especially after taking fees into account.
Without any clear benefit to mutual fund investing, Ramsey’s advice that you pay more to put your money into them instead of choosing cheaper ETFs could end up needlessly costing you thousands in added fees over your investing career.
2. You can earn a 12% average annual return
Ramsey promises it’s possible to earn a 12% average annual return on investments. But if you listen to this advice, you’re very likely to have a major shortfall when it comes time to retire.
Ramsey’s “12% reality” is based on the simple average returns of the S&P 500, which he reports as 11.64% from 1928 to 2020. The problem is, simple average returns aren’t the most accurate way to measure how your investments perform. Here’s why.
Say you invested $5,000 and your investment went up 20% in the first year and down 20% the next year. Your simple average return is 0% since your investment went up and down by the same percentage. But you don’t actually end up with $5,000 at the end of year two. Your 20% gain after year one left you with $6,000. But, when you lose 20% off $6,000 – or $1,200 – you end up with $4,800 at the end of year two. Your actual ROI is -4%, not 0%.
As you can see, using simple average returns isn’t going to paint a very realistic picture of how your investment is likely to perform. Instead, you need to use the Compound Annual Growth Rate (CAGR), which shows a more realistic 10.04% average S&P 500 return from 1928 to 2020.
Overestimating expected returns by almost 2% is really damaging, especially when you’re talking about retirement planning over several decades. You’re going to be left with a lot less money than you expected if you follow this Ramsey advice.
3. You should pay off all non-mortgage debt before investing for retirement
Ramsey argues you should do the following things before starting to invest for retirement:
- Pay off all of your debt expect for your home mortgage
- Save an emergency fund that covers three to six months of living expenses
Here’s the problem. This could take years. And during all that time, you’d be missing out on employer 401(k) matches, which are literally free money. You’d also be missing out on tax subsidies for investing in a 401(k) or IRA. And you’d be losing the chance to earn returns in the stock market.
In other words, you’ll be giving up huge opportunities to shore up your financial security as a retiree. And, if you’re doing this to pay off low-interest car loan debt, which could be at a rate of around 4%, you’re limiting your ROI needlessly.
You should absolutely prioritize debt payoff and saving for emergencies – but not necessarily at the expense of your retirement funds.
Generally, it’s a good idea to pay off very high-interest debt, such as payday loans, and to have some emergency money in the bank before you begin investing for retirement. But once you’ve got a starter emergency fund of a few thousand dollars and you’ve got payday loans paid off, prioritizing earning a 401(k) match can make a lot more sense than putting every spare dollar toward other debt. And there’s generally little reason to pay off low-interest loans early when you stand a solid chance of earning a higher return by investing.
Instead of listening to this Ramsey retirement planning advice, make retirement investing a priority, set realistic expectations for your ROI, and focus on both historic returns and fees when choosing investments – which usually means picking ETFs over mutual funds. If you do, you’ll likely end up a lot better off.
Offer from the Motley Fool
The $16,728 Social Security bonus most retirees completely overlook
If you’re like most Americans, you’re a few years (or more) behind on your retirement savings. But a handful of little-known “Social Security secrets” could help ensure a boost in your retirement income. For example: one easy trick could pay you as much as $16,728 more… each year! Once you learn how to maximize your Social Security benefits, we think you could retire confidently with the peace of mind we’re all after. Simply click here to discover how to learn more about these strategies.
The Motley Fool has a disclosure policy.
The Motley Fool is a USA TODAY content partner offering financial news, analysis and commentary designed to help people take control of their financial lives. Its content is produced independently of USA TODAY.