Investing

DR 075: The Reality of Dave Ramsey’s 12% ‘Reality’ (and why it really matters)

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Recently I reviewed what Dave Ramsey calls his Endorsed Local Providers (ELPs). As I was doing research for that review I learned of Dave’s view that historically the S&P 500 has returned 12%. I also learned that he believes it will continue to do so over the long run.

This was curious to me for several reasons. First, it’s common knowledge that the compound annual growth rate of the S&P 500 since 1926 is 10%, not 12% (the S&P 500 as we know it today was formed in 1957, but we can trace variations of it back further). Second, every investing expert I’ve ever read or listened to says the same thing--10%. And finally, I know of no expert or study that predicts 12% returns going forward.

So I dug into this a little bit and learned from the Ramsey website that he gets very specific. He claims that from 1926 to 2011 the S&P 500 returned 11.69%. That’s not the kind of number you just make up out of thin air. It’s wrong, of course, but the better question is how he came up with it in the first place.

I literally spent days trying to reverse engineer his 11.69%. In the car one day it finally hit me. He's taking a mathematical average of the yearly returns of the S&P 500. I checked this theory against return data and replicated his number to within a few hundredths of a percent. I emailed his company for confirmation, but have yet to receive a reply.

And that brings us to today's topic: average annual returns vs. annualized returns (also called compound annual growth rate).

Average Returns vs. Annualized Returns

In today’s podcast I cover the difference between average returns and annualized returns. For example, image investing $10,000 for ten years. In one scenario you earn 10% each and every year. In the second you earn 5% in year one, 15% in year two, 5% in year three, and so on. In both cases, the average return is the same, 10%. The amount of money you have at the end of 10 years, however, is very different.

Listen to today’s podcast to understand why. We’ll also cover why this difference is so important. Trust me, your future retirement is at stake.


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