One of the more popular financial gurus in America who promotes financial advice is Dave Ramsey. Few people have trouble with his recommendations to get out of debt, save up an emergency fund, and invest money for long-term security. His argument that an investor can expect to get a long-term annual return of 12 percent is where many people question his advice.
When people look at the annual returns of the S&P 500 or some of the other leading indices, dividends are frequently left out of the equation. Ramsey claims that the S&P 500 (and its predecessors) returned an average of 11.69 percent annually from 1926 to 2011. This is really close to the amount shown by the calculator available at moneychimp.com, which shows an annual return of 11.84 percent over the same period of time. If we move the parameter to the end of 2015, the return grows to 12.02 percent. Each dollar invested in 1926 would be worth nearly $5,500 today.
Image from moneychimp.com
However, if we look at the true growth rate, the return becomes much less impressive. A 12.02 percent return drops to 10.04 percent. One of the more common examples to show the fallacy of relying on "average" returns involves an investment of $1 that drops 50 percent in one year. The investment would then be worth 50 cents. The next year, there is a positive 100 percent return that brings the investment back to its original value of $1. The average return would be 25 percent, while the real return (better known as the compound annual growth rate, or CAGR) is 0 percent. The investor has the same amount of money invested that they started out with in this hypothetical example.
If we drop dividends from the equation, the average return between 1926 and 2015 drops to an average of 7.71 percent or 5.81 percent on a compounded basis. This is much different than the 12 percent average that's claimed. The overall return on each dollar drops from the $5,496 shown above to only $161.53 when dropping dividends from the equation. This shows the importance of dividends in the overall return. It also shows that Ramsey's claim is not quite as far-fetched as it might seem at first blush if dividends are included in the growth rate. Of course, it is also important to remember that inflation can take a huge cut out of this return. When inflation and dividends are added in, the overall return is just below 7 percent on a compounded basis.
Image taken from moneychimp.com
When looking at these returns, one might rightly argue that hardly anyone will have a 90-year investing horizon without a massive breakthrough on the problem of aging. This makes the timing of investment very important. Using the same calculator from moneychimp.com, it's quite easy to change the parameters to look at other time frames. Looking at the CAGR between 1960 and 1979, generally looked at as a time of stock stagnation, the return was only 6.78 percent over this 20-year period. Without accounting for dividends, the return drops to 2.99 percent. While much higher than the return one could expect from stuffing money in a mattress, it's much lower than the 12 percent annual return that Ramsey claims.
The next twenty years, on the other hand showed massive gains. The CAGR between 1980 and 1999 was 17.99 percent (13.95 without dividends included). The decade of the 2000s has been called a lost decade for equity investors, and returns between 2000 and the end of last year are only 4.02 percent even when dividends are included. However, this includes two massive recessions, and returns since 2009 at the trough of the Great Recession have averaged 14.86 percent (12.38 percent without dividends). The overall period between 1980 and 2015, a better baseline for an investing life than 90 years, had a return of 11.56 percent when adding in dividends.
Dave Ramsey makes a controversial claim that investors can expect to earn a 12 percent return on average when putting their money to work. This is widely contested, but when adding dividends into the returns, the number is not radically off when looking at the average returns. However, the CAGR makes the argument a bit less favorable and brings the return to around 10 percent. Furthermore, those who invest at a market high will see lower returns over the long term, while those who dollar cost average over a medium to longer period of time will see better returns as they are able to take advantage of stocks that are on sale. It's generally not advisable to try and time the market, but investing when the market is booming is generally not the best way to make money. Dividends that are reinvested can also prove to be the "secret sauce" that can bring investment returns up and improve gains.
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I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am not a licensed financial professional. Please make sure to do due diligence and consult a professional before investing in securities as losses up to and including all money invested can occur.