As a financial advisor, I often read about the investment philosophies of other purveyors of the industry. As part of my church community, Dave Ramsey and his “Financial Peace Academy,” enter a few of my conversations with my clients with whom I also share the same faith. I have had the opportunity to listen to his program twice.
One aspect of his program I do wish to address is his investment philosophy and the historical and practical use of mutual funds. To be exact, his reference to a mutual fund that has averaged a 12% annual return since 1934 and his advice to establish an all-equity investment portfolio. He even claims, on his website, the S&P 500 averaged 11.7% since 1926.
The reason Ramsey uses this particular mutual fund, and the 12% annual return is to illustrate the power of compounding and over a long period of time, or as we say in the business, “The time value of money.” As Mr. Ramsey has so often pointed out, a $100/month investment for 40 years, averaging a 12% annual return, compounded monthly would result in a portfolio worth $1,176,477.25.
It should be pointed out that Mr. Ramsey is not a financial advisor. He is not licensed to give advice or recommend a security in exchange for money. That is why he never names any specific mutual funds. If he did, he would be breaking the law.
Having been in the business long enough, I know exactly which mutual fund he is referencing when he talks about a mutual fund that has averaged a 12% return since 1934. I have also confirmed this with professionals in the field. It is the American Funds Investment Company of America (symbol: AIVSX).
There are a few facts about the ICA, that support Ramsey’s claims. If one invests $100/month for 40 years, s/he would in fact average an annual return around 12%. An analysis of 40 year rolling averages showed that the worst 40 year period (1935-1975) averaged 10.22% and the best 40 year period (1960-2000) averaged 13.86%. The median 40-year return yielded an annual rate of 12.46%.
The last 20 years paint a different picture, though. ICA has averaged a 9.3% return in the last 20 years, and only a 7.4% return in the last ten years (data provided by Reuters). While these returns still outperform the S&P 500, they are not the 12% Mr. Ramsey uses in his own illustrations.
Why is this important? Mr. Ramsey uses the 12% annual return in his illustrations to motivate people to save for retirement. He does hedge, however, by asking, “What if I’m only half right?” Well, for a 40-year period, that would mean that the average annual return is around 9.5%. That is a big difference.
It is important to understand that the average annual return for the S&P 500 (Shiller) since 1934 is around 10.6%. This includes reinvested dividends. The average since 1871 is around 9%. One needs to remember this, as a grain of salt, when attending one of Mr. Ramsey’s seminars.
It is fun to watch Ramsey as he spins his 12% annual returns to demonstrate the power of compounding and systematic investment. It is intellectually dishonest, though, to act as if this is normal. There is a biblical argument to be made for 8%, Shiller’s data shows a 9% return, and one can even reach for 10%, if he chooses. It is time, though, to stop saying 12%.