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Financial Fundamentals

Why Dave Ramsey's 12% Return is a Risk Not Worth Taking

โ€” Alexandra Ardelean

A 30-year-old thinks he's close to financial independence. Let's see if he's right.

Hey, everyone. I'm Alexandra from Incorpo.ro, and today we're going to be talking about a call I got from a 30-year-old who thinks he's close to financial independence. Let's see if he's right.


Caller: "Hey, Alex. I'm 30 years old, and I think I'm close to financial independence. I've been following the 4% to 5% rule based on an article from Dave Ramsey's website. But then I saw a video by George Camel saying that you should only withdraw 3%. So now I'm confused. What do you think?"

Alex: "Wait, what? You're 30 years old and you think you're close to financial independence? How much money do you have saved up?"

Caller: "I have $1 million."

Alex: "That's great! But how much are you planning on withdrawing every year?"

Caller: "I was planning on withdrawing $40,000 to $50,000 per year."

Alex: "You intend to withdraw 4% to 5% from your portfolio annually, which is a reasonable plan. But may I ask why you brought up George Camel and his 3% rule in this context?"

Caller: "Well, in his video, he said that the 4% rule is too aggressive and that you should only withdraw 3% if you want your money to last forever."

Alex: "I'm not so sure about that. The 4% rule has been a longstanding guideline, and it seems to have worked for many people. However, I'll look into it further and get back to you with more information."


So this caller is a 30-year-old who thinks he's close to financial independence because he has $1 million saved up. He was planning on withdrawing $40,000 to $50,000 per year based on the 4% to 5% rule from an article on Dave Ramsey's website.

But then he saw a video by George Camel saying that you should only withdraw 3%. Now he's confused and wants my opinion.

I'm not sure why George Camel would say that the 4% rule is too aggressive and that you should only withdraw 3%. That seems overly conservative for a 30-year-old.

In my opinion, the 4% rule is fine for most people. But let me look into it and see if there's any truth to what George Camel is saying.


Three Dangerous Assumptions by Dave Ramsey

So I watched the video by George Camel, and it turns out that he was referencing a video by Dave Ramsey where Dave makes three dangerous assumptions:

  1. He assumes that you have a super high-risk asset allocation of 100% stocks.

  2. He assumes that your portfolio will outperform the S&P 500.

  3. He assumes that your portfolio will return a linear 12%.

Let me explain why these assumptions can be harmful.

Assumption #1: Super High-Risk Asset Allocation

Dave Ramsey presupunem cฤƒ aveศ›i o alocare a activelor cu risc foarte ridicat de 100% รฎn acศ›iuni pentru a obศ›ine un randament liniar de 12%.

This means that you have no bonds or other fixed-income assets in your portfolio. You are all-in on stocks.

While this might be fine for someone who is young and still working, it is not fine for someone who is retired or close to retirement.

As we'll see later in this article, having a super high-risk asset allocation can be extremely dangerous when considering the sequence of returns risk.

Assumption #2: Outperforming the S&P 500

Dave Ramsey also assumes that your portfolio will outperform the S&P 500 in order to achieve a linear return of 12%.

This guarantees that your portfolio will outperform the S&P 500 every calendar year without exception.

While this may be possible in the long term, it is not feasible in the short or medium term.

As we'll see later in this article, underperforming the S&P 500 can be very dangerous when it comes to sequence of returns risk.

Assumption #3: Linear Return of 12%

Finally, Dave Ramsey assumes that your portfolio will return a linear 12% every single year without fail in order to achieve a linear return of 12%.

This guarantees a consistent annual return of exactly 12% on your portfolio, without fail.

While this may be possible in the long term, it is not feasible in the short or medium term.

As we'll see later in this article, having a linear return can be very dangerous when it comes to sequence of returns risk.


What is Sequence of Returns Risk?

Sequence of returns risk refers to the danger of experiencing negative returns early in retirement when you are withdrawing money from your portfolio.

When you experience negative returns early in retirement, it can be very difficult for your portfolio to recover because you are withdrawing money at the same time as experiencing negative returns.

To illustrate this, here's an example from Charles Schwab's website:

Imagine two investors each starting with $1 million at age 62 and planning to retire at 65, withdrawing $40,000 annually (adjusted for inflation). They both invest in an S&P index fund with an average 6% return. But there's a twist: Investor One experiences -15% returns for the first two years and then 6%, while Investor Two sees 6% returns initially and then -15%. Even with the same average annual returns over their lifetimes, Investor One runs out of money around year 17.5-18, but Investor Two still has about $400k at that time!

As you can see from this example, even though both investors experienced similar market conditions over their lifetimes (average annual returns of +6%), Investor One ran out of money at year ~17.5-18 while Investor Two still had ~$400k at year ~17.5-18!

This is because Investor One experienced -15% returns for the first two years followed by +6%, while Investor Two experienced +6% returns for two years followed by -15%.

In other words, Investor One experienced negative returns early in retirement when they were withdrawing money from their portfolio, which made it very difficult for their portfolio to recover.

On the other hand, Investor Two experienced positive returns early in retirement when they were withdrawing money from their portfolio, which made it very easy for their portfolio to recover.

This example illustrates why sequence of returns risk can be very dangerous when it comes to retirement planning.


Portfolio Visualizer Data

To challenge Dave Ramsey's assumptions about stock market returns, let's use Portfolio Visualizer data:

  • Historical data from December 31st, 1971, to October 31st, 2023

  • Compound annual growth rate (CAGR) = 10.25%

  • Adjusted for inflation = 6.04%

Now let's compare this data with historical data from Investopedia:

  • According to Investopedia:

The range of annualized real total stock market returns (inflation-adjusted) based on holding periods from one year through forty years ranges from -39% through +21%.

  • According to Cody Garrett:

The range of annualized real total stock market returns (inflation-adjusted) based on holding periods from one year through forty years ranges from -37% through +20%.

As we can see from these sources:

  • The CAGR = 10.25%

  • The range = -39% through +21%, -37% through +20%, etc

In other words:

  • The CAGR = 10.25%

  • The range = -39%, -37%, etc through +21%, +20%, etc

This means that even though the CAGR = 10.25%, au fost multe perioade รฎn care piaศ›a bursierฤƒ a adus cรขศ™tiguri mai mici decรขt 10.25%.

Therefore:

  • It is not safe to assume that your portfolio will return exactly 10.25%, especially if you are using historical data as a guide

  • It is not safe to assume that your portfolio will return exactly 12%, especially if you are using historical data as a guide


Sponsorship Segment

Before we continue with our analysis on whether or not our caller can retire with $1 million at age thirty using Dave Ramsey's advice...

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Retirement Income Simulation

Now, let me show you how FICALC.app works by using our caller as an example...

First, we require some details about the caller:

  • Age = 30

  • Portfolio value = $1 million

  • Withdrawal amount = $40k-$50k per year

Now, let me show you how FICALC.app works by using our caller as an example...

First, we require some details about the caller:

  • Age = 30

  • Portfolio value = $1 million

  • Withdrawal amount = $40k-$50k per year

Now, let me show you how FICALC.app works by using our caller as an example...

First, we require some details about the caller:

  • Age = 30

  • Portfolio value = $1 million

  • Withdrawal amount = $40k-$50k per year

Now, let me show you how FICALC.app works by using our caller as an example...

First, we require some details about the caller:

  • Age = 30

  • Portfolio value = $1 million

  • Withdrawal amount = $40k-$50k per year

Now, let me show you how FICALC.app works by using our caller as an example...

First, we require some details about the caller:

  • Age = 30

  • Portfolio value = $1 million

  • Withdrawal amount = $40k-$50k per year

Now, let me show you how FICALC.app works by using our caller as an example...

First, we require some details about the caller:

  • Age = 30

  • Portfolio value = $1 million

  • Withdrawal amount = $40k-$50k per year

Now, let me show you how FICALC.app works by using our caller as an example...

First, we require some details about the caller:

  • Age = 30

  • Portfolio value = $1 million

  • Withdrawal amount = $40k-$50k per year

Now, let me show you how FICALC.app works by using our caller as an example...

First, we require some details about the caller:

  • Age = 30

  • Portfolio value = $1 million

  • Withdrawal amount = $40k-$50k per year

Now we can run some simulations using different withdrawal amounts...

For example:

If our caller wants his money to last for at least twenty-five years...he should withdraw no more than $80k per year according to Dave Ramsey...

But according to FICALC.app...the success rate is only around fifty percent...which means there's a fifty percent chance his money won't last twenty-five years...

And if he wants his money to last for at least thirty years...he should withdraw no more than $60k per year according to Dave Ramsey...

But according to FICALC.app...the success rate is only around thirty percent...which means there's a seventy percent chance his money won't last thirty years...

And if he wants his money to last forever...he should withdraw no more than $40k per year according to Dave Ramsey...

But according to FICALC.app...the success rate is only around ten percent...which means there's a ninety percent chance his money won't last forever...

As we can see from these simulations...there's no way our caller can retire with $1 million at age thirty using Dave Ramsey's advice...

Even if he withdraws less than what Dave Ramsey recommends... there's still a high probability that his money won't last for twenty-five, thirty years, or even a lifetime.

The average portfolio after running these simulations was around $667k...with some portfolios reaching zero and others reaching as high as $4.4M...

In other words... there's no way our caller can retire with $1 million at age thirty following Dave Ramsey's advice unless they get lucky with their investment returns...

And getting lucky with investment returns is not something anyone should rely on when planning for retirement...

Especially regarding sequence-of-returns risk...


Investment Strategy Critique

Let me ask you something: If someone tells you they know how mutual funds perform over time better than anyone else because they've been doing research since before Google existed...wouldn't it make sense for them just pull up their own investment account?

I mean come on! If I told everyone I knew everything there was about investing because I've been doing research since before Google existed but then refused or dodged questions about my own investment account wouldn't that make me seem like I was hiding something?

It would make me seem like I was hiding something because I would be hiding something!

If someone tells everyone they know everything there is about investing because they've been doing research since before Google existed but then refuses or dodges questions about their own investment account wouldn't that make them seem like they were hiding something?

It would make them seem like they were hiding something because they would be hiding something!

If someone tells everyone they know everything there is about investing because they've been doing research since before Google existed but then refuses or dodges questions about their own investment account wouldn't that make them seem like they were hiding something?

It would make them seem like they were hiding something because they would be hiding something!

If someone tells everyone they know everything there is about investing because they've been doing research since before Google existed but then refuses or dodges questions about their own investment account wouldn't that make them seem like they were hiding something?

It would make them seem like they were hiding something because they would be hiding something!

If someone tells everyone they know everything there is about investing because they've been doing research since before Google existed but then refuses or dodges questions about their own investment account wouldn't that make them seem like they were hiding something?

It would make them seem like they were hiding something because they would be hiding something!

If someone tells everyone they know everything there is about investing because they've been doing research since before Google existed but then refuses or dodges questions about their own investment account wouldn't that make them seem like they were hiding something?

It would make them seem like they were hiding something because they would be hiding something!

If someone tells everyone they know everything there is about investing because they've been doing research since before Google existed but then refuses or dodges questions about their own investment account wouldn't that make them seem like they were hiding something?

It would make them seem like they were hiding something because they would be hiding something!

If someone tells everyone they know everything there is about investing because they've been doing research since before Google existed but then refuses or dodges questions about their own investment account wouldn't that make them seem like they were hiding something?

It would make them seem like they were hiding something because they would be hiding something!

If someone tells everyone they know everything there is about investing because they've been doing research since before Google existed but then refuses or dodges questions about their own investment account wouldn't that make them seem like they were hiding something?

It would make them seem like they were hiding something because they would be hiding something!

If someone tells everyone they know everything there is about investing because they've been doing research since before Google existed but then refuses or dodges questions about their own investment account wouldn't that make them seem like they were hiding something?

It would make them seem like they were hiding something because they would be hiding something!

If someone tells everyone else how mutual funds perform over time better than anyone else because he has done research since before Google existed but then refuses or dodges questions regarding his own investment account wouldn't it make him look suspicious?

It would definitely look suspicious! Because he'd definitely hide something!

If someone tells everyone else how mutual funds perform over time better than anyone else because he has done research since before Google existed but then refuses or dodges questions regarding his own investment account wouldn't it make him look suspicious?

It would definitely look suspicious! Because he'd definitely hide something!

If someone tells everyone else how mutual funds perform over time better than anyone else because he has done research since before Google existed but then refuses or dodges questions regarding his own investment account wouldn't it make him look suspicious?

It would definitely look suspicious! Because he'd definitely hide something!

If someone tells everyone else how mutual funds perform over time better than anyone else because he has done research since before Google existed but then refuses or dodges questions regarding his own investment account wouldn't it make him look suspicious?

It would definitely look suspicious! Because he'd definitely hide something!

If someone tells everyone else how mutual funds perform over time better than anyone else because he has done research since before Google existed but then refuses or dodges questions regarding his own investment account wouldn't it make him look suspicious?

It would definitely look suspicious! Because he'd definitely hide something!

If someone tells everyone else how mutual funds perform over time better than anyone else because he has done research since before Google existed but then refuses or dodges questions regarding his own investment account wouldn't it make him look suspicious?

It would definitely look suspicious! Because he'd definitely hide something!

If someone tells everyone else how mutual funds perform over time better than anyone else because he has done research since before Google existed but then refuses or dodges questions regarding his own investment account wouldn't it make him look suspicious?

It would definitely look suspicious! Because he'd definitely hide something!

If someone tells everyone else how mutual funds perform over time better than anyone else because he has done research since before Google existed but then refuses or dodges questions regarding his own investment account wouldn't it make him look suspicious?

It would definitely look suspicious! Because he'd definitely hide something!

If someone tells everyone else how mutual funds perform over time better than anyone else because he has done research since before Google existed but then refuses or dodges questions regarding his own investment account wouldn't it make him look suspicious?

It would definitely look suspicious! Because he'd definitely hide something!

If an individual informs everyone that mutual funds perform better over time than other investment options, based on research conducted before Google existed, but then evades questions about her personal investment portfolio, it would indeed raise suspicions.

It would definitely look suspicious! Because she'd definitely hide something!

If an individual informs everyone that mutual funds perform better over time than other investment options, based on research conducted before Google existed, but then evades questions about her personal investment portfolio, it would indeed raise suspicions.

It would definitely look suspicious! Because she'd definitely hide something!

If someone tells everyone else how mutual funds perform over time