SPOILER ALERT: In today’s post, I’ll make the case that you should own VTSAX ahead of any mutual funds Dave Ramsey suggests.
Dave Ramsey is essentially the Godfather of the Get out of Debt movement. I love most all of what Dave Ramsey preaches. He has provided value to so many lives and has been a personal inspiration for myself to try to positively affect people and families financially in the way he has.
If you’ve ever heard his radio show, he is a tough love kind of guy who offers guidance to people that clearly have minimal financial sense. I don’t blame the people. Our education system does a HORRIBLE job at educating us on how to manage and invest money and that creates markets for people like Dave Ramsey and the Get Rich or Die Trying blog.
That said, I’ve always cringed every time Dave Ramsey offers suggestions on investing in mutual funds. Personally, his advice there is trash and you’d be better served to do your own due diligence. I’m not why he gives the advice on mutual funds that he does. Maybe it’s because he only has a minute or two to help out the caller. Maybe it’s because the ELP’s (Endorsed Local Providers) that he promotes give him a financial incentive to push the products he does. Whatever it may be, I’ll provide a dissenting opinion below that will offer what I think is a better suggestion to mutual fund investing than what Dave does.
Let’s dissect Dave’s advice and see where he may be pointing people down the wrong path, shall we?
Your eyes do not deceive you. Let’s not get caught up in the exact numbers, but the bottom line is there are, and have been for some time, WAY more mutual funds to choose form than actual stocks. Pretty amazing, right? Well, let’s just say the investment advice business is pretty lucrative for the mutual fund companies.
Given that shocking mathematical discrepancy, no wonder it’s so hard to determine which mutual fund you should put your 401k or your hard earned extra money into. In steps Dave Ramsey with his mutual fund investment strategy recommendation.
Find a good growth oriented fund that will get about 12% per year
Dave suggests to look at funds that fall into the following 4 categories: growth, growth and income, aggressive growth, and international
Dave’s next suggestion: You’ll want an experienced manager calling the shots for your mutual fund – someone with 5 to 10 years of experience.
Finally, Dave suggests you focus on mutual funds with a cost ratio of no more than 1%
Let’s break this statement down. If only finding one of these mutual funds was like picking up leaves in your front yard, it would all be so easy. First of all, according to this CAGR (Compound Annual Growth Rate) Calculator , from 1871 to 2014, the S&P 500 grew at an annualized rate of 10.77%, including dividends reinvested. We’ll forgive Dave for suggesting 12% because 1) some mutual funds will beat the S&P 500 (but very, very few over the course of even a decade, much less longer periods) and 2) maybe 1.23% is a rounding error.
However, upon closer analysis, that 10.77% number I quoted you didn’t take into account inflation. In doing that, the return, including dividends, drops to 8.58%. On a percentage basis, that’s almost 30% lower than what Dave is suggesting (8.58% being 71.5% of 12%). Ok. Let’s let that thought sit for now and look at some of his other recommendations.
While I’m not opposed to diversifying in this way there’s a couple of flaws. First of all, there’s no bonds or bond funds mentioned. Maybe he’s suggesting just to invest in these 4 types of funds with the percentage of your portfolio that you want to put in stocks. He doesn’t typically mention bonds or percentage of your allocation that should to there, so I have to assume he’s essentially suggesting an all stock portfolio. That’s not something anyone really should ever do. Even the most risk tolerant.
Secondly, you would probably be shocked at the amount of overlap in these funds. By that I mean, the percentage of the same stocks that are held in each of these funds. As an example, no matter which of the 9,000+ mutual funds you put your money into, you’re almost guaranteed to own AAPL and in largely the same percentage.
You’ll want to be careful here as, even though Dave is recommending 4 different categories of mutual funds, you may find that if you don’t really dig into the allocations of the funds you select, you may be no more diversified with 4 funds than you would be with 1 or 2 funds.
Even though a fund may be classified as “International”, you’d probably be surprised to know that certain types of “International” funds can invest a certain percentage of their fund (sometimes up to 60%) in U.S. based stocks. While there may be some logic there that U.S. companies are typically global and do a significant percentage of their revenue overseas, thereby making them “International” in a sense, it would be hard to argue that loophole would be expected given the category of the fund.
Again, while this may be true, it doesn’t tell the whole story. 5 or 10 years is a relatively short time to own a mutual fund and may skew results. Regardless, the results of the fund over time are only indicative of the people that are running the fund. If you’re not paying attention to when they come and go, you may end up having your money parked in a fund that was run successfully by someone that is no longer there.
A perfect example is Peter Lynch. He’s the fame investment manager of Magellan funds. When he retired from managing the fund in 1990, had compounded at 29.2% per year from 1977 (when he took over) until 1990. In the 20 years since he retired (1991 t 2010), the Magellan fund beat the S&P 500 only 8 out of 20 years.
It is very important to pay attention to who is running your mutual fund as they make the decisions about where your money goes.
1%?!? That’s 100 basis points. A significantly large expense ration, but surprisingly nowhere near the most expensive.
You see, what mutual fund marketing won’t tell you is, while the fund may make x % for the year, you then have to back out the expense ration, fees (for buying and selling in the actively managed fund) and taxes. All of those together take a HUGE bite out of your return over the long haul of 10, 20 or 30+ years.
Morningstar tracks 1,500 large cap growth funds and the average expense ration was 1.22% in 2014. That’s jaw dropping expensive.
So, given all that and what Dave suggests you should do, there is another alternative.
In 1975, John Bogle create the S&P 500 Index fund or my personal favorite VTSAX. VTSAX is the Admiral Fund (lower fees) which represents the Total Stock Market Index (i.e. most diversified fund). This is the reason I suggest that Dave is giving bad advice. The math has proven out that you have a less than 1 in 20 chance of picking a mutual fund that will beat the Vanguard S&P 500 Index fund over a 10 year period.
While that means that, if you’re that lucky person that banks on a young Peter Lynch before anyone has ever heard of him and get it right, you may do better than the S&P 500. How much better remains to be seen, but you will only know through the rear view mirror of hindsight 10 or 20 years from now.
Bogle’s Vanguard product essentially debunks every bit of mutual fund advice Dave Ramsey gives. Let’s review his suggestions point by point:
1) Find a good growth oriented fund that will get about 12% per year
Since we showed that the whole market on average, inflation not included, doesn’t typically go up 12% per year, why risk picking a bad fund manager for some limited upside when you can get almost 12% in an unmanaged, low-cost fund?
2) Look at funds that fall into the following 4 categories: growth, growth and income, aggressive growth, and international
Purchasing VTSAX will cover each of these categories with the large, global U.S. companies covering the international portion. There still should be some % of one’s portfolio in cash and bonds as your personal risk tolerance may vary. Plus, instead of making 4 different decisions, you could make 1.
3) You’ll want an experienced manager calling the shots for your mutual fund – someone with 5 to 10 years of experience.
As we’ve made abundantly clear above, a mutual fund will only do as well as the person or people running it, You have to keep up with the comings and goings of those people. Sure, the head honcho can train his or her successor, but the results will never be exactly the same as everyone has different strengths and weaknesses.
With VTSAX, there is no manager so you don’t have to worry about transitioning from one person to the next over time.
4) Focus on mutual funds with a cost ratio of no more than 1%.
If you take nothing else away from this blog post, please take this away. 1% (or what the industry insiders would call 100 basis points or bps (pronounced bips)) is a RIDICULOUS expense ratio. I can’t stress this enough.
Why pay a premium for someone to manage your fund so that sometimes they can beat the unmanaged S&P or Total Market Index Fund. Remember, you have a < 5% change (1 in 20) of guessing the right fund out of over 9,000 that will beat the market. The upside just isn't sustainable and therefore isn't worth it.
The expense ratio as of the writing of this article is .05%. That’s 5 basis points. A 1% expense ratio fund that Dave Ramsey suggests is 20 TIMES more expensive than VTSAX. Are you going to get 20X the return or expertise when we’ve already proven that the overwhelming majority of mutual fund managers can’t beat the market over 10 years or more? Heck to the NO!
There you have it. I know the Get Rich or Die Trying community is a little smarter than the average investor out there. I’ve made the case for you in black and white math. It probably wouldn’t pay Dave as well to recommend VTSAX with a well balanced bond and cash portfolio included or maybe he has some other reason to suggest buying managed funds that charge you roughly 1% OR MORE to manage your money.
I’m more interested in arming you with the knowledge you need to make good, life long decisions on your investments.
As always, do your own due diligence and consult your professional financial advisor, but come armed with the knowledge I’ve shared with you today.
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