Why Dave Ramsey Is Wrong On Mutual Funds

Dave is right on many things, but here's where he gets mutual funds wrong

Dave Ramsey
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You’ve probably heard of Dave Ramsey if you've been saving money, trying to get out of debt, or thinking about investing. Ramsey's advice might seem right and even smart, but he gets some key points wrong when it comes to mutual funds.

What Does Dave Ramsey Get Right?

Ramsey gives his radio show listeners and book readers good financial planning advice in many ways. His message is simple, easy to understand, and ioften entertaining. He focuses on the psychology of money. Ramsey knows that an investor's worst enemy is often himself. You might fail early, or you won’t even get started if your goals don’t feel like they're within reach.

Failure to act can be more dangerous than applying less-than-ideal investment advice. Ramsey's "baby steps" to financial freedom can be helpful with getting you started, but his investment advice borders on dangerous when it comes to mutual funds.

The Dave Ramsey Investing Philosophy

Ramsey's investment philosophy for mutual funds is explained on his website. He recommends mutual funds for your employer-sponsored retirement savings and your IRAs. He says you should divide your investments equally among four types of funds:

  • Growth
  • Growth and Income
  • Aggressive Growth
  • International

Where Are the Bonds?

One of the most important factors of asset allocation is that you have more than one asset type. But Ramsey's four-fund mix includes only one asset type. There are only stock funds in this group, no bond funds or cash, such as a money market.

A portfolio made up of 100% stocks isn’t suitable for most of Ramsey's audience. In fact, it’s wrong for almost everyone.  

Overlap Puts You at Risk

Dave Ramsey suggests that you should hold four mutual funds in your 401(k) or IRA, but his four-fund mix has a lot of potential for overlap. This occurs when an investor owns two or more mutual funds that hold similar securities.

For example, an inexperienced investor might be looking at a 401(k) plan that offers Vanguard mutual funds. ​The Vanguard 500 Index Fund Admiral Shares (VFIAX) is a common choice. You most likely wouldn't know whether this fund is "growth," "growth and income," or neither if you're just starting out. What if Vanguard Growth and Income (VQNPX) were another choice? Would you know if there were overlap with VFIAX?

You can go to Morningstar.com and search for VQNPX to find out. Look for the link to "Risk" at the top left of that page, and click on it. Scroll down to "R-squared" under "Risk & Volatility Measures." You'll see three numbers, all of them close to 99. This means that VQNPX has a 99% correlation to the S&P 500 index fund. They're pretty much identical.

You might think that an international stock fund wouldn't invest in stock found in their domestic growth or growth-and-income fund, but it can invest a percentage in U.S. stocks if the fund is classified as "world stock." This creates still more overlap.

Ramsey's four-fund mix could lead to the same diversification as just holding one or two stock funds. Your account value could fall much more than it would if you had a diverse mix of stock funds and bond funds if and when U.S. stock prices fall.

Where Are the No-Load Funds?

Dave Ramsey suggests using Class A shares, which are loaded funds. That means you'd pay commissions to a broker or adviser. Why wouldn't he recommend no-load funds? My guess is that he tells his listeners to use an "Endorsed Local Provider (ELP)." This is a broker or adviser Ramsey recommends.

Better advice would be to suggest using a "fee-only" adviser who can recommend no-load funds—someone who only gets paid for the advice they give and not the products they sell.

He's Wrong About Risk Tolerance

Ramsey says that investors might have to adjust the aggressive portion of their portfolio whether their risk tolerance is low. This would mean you'd have less time to keep your money invested.

Risk tolerance ​refers to market risk and the ups and downs that you can tolerate. The amount of risk an investor can handle is about emotions or feelings. It's not a period of time.

An 80-year-old can have high risk tolerance, and a 20-year-old can have low risk tolerance.

Ramsey's definition of "risk tolerance" is the amount of risk you can afford to take on.

It might not make sense to have 100% of your retirement savings tied up in stocks just one year before you plan to retire, even if you consider yourself to be an aggressive investor. But you won't be served well by putting all your 401(k) money in a stable value fund if you have 40 years until retirement but you have low risk tolerance.

The Best Basics of Investing

Here are some of the best ideas that Ramsey shares with his audience, along with some of his worst.

Use a Core-Satellite Portfolio Design

You select a "core" fund and build around it with "satellite" funds with this type of portfolio structure. For example, a good core would be an S&P 500 Index fund at around 40% allocation. Foreign stock, small-cap stock, and bond funds would be at around 10% to 20% each.

Use Diverse Fund Categories

This is the root of Dave Ramsey's portfolio weakness. His four fund categories are all similar in their makeup. This creates a ticking time bomb for overlap.

For example, three of the four groups that Ramsey recommends—growth, growth and income, and aggressive growth—could all be large-cap domestic stock funds. These stock funds made up one of the worst areas of the market during the 2007 to 2009 bear market. A diversified portfolio would have prevented this problem.

Understand Risk Tolerance

Time has nothing to do with tolerance. Time is measured in months or years, and tolerance is a feeling or emotion about the ups and downs of your account balance.

Risk tolerance is normally gauged by questionnaires that can arrive at inaccurate results. For example, one of the questions might ask how you would feel if you were to lose 20% of your account value over the course of a few months or a year. Would you sell now, wait and decide later, or do nothing?

But that is like asking, "What would you do if your best friend were in a car accident?" There's really no way of knowing unless you've been in that situation.

Choose the Right Asset Allocation

You can decide on asset allocation after you've figured out your level of risk tolerance. This is the mix of investment assets—stocks, bonds, and cash—that constitutes your portfolio. It should reflect your level of risk tolerance, which might be aggressive or high, moderate or medium, or conservative or low.

How to Choose the Best Funds

Dave Ramsey helps beginners by encouraging them to invest in mutual funds, but he doesn't say much about how to choose the best funds. You need a good mutual fund research site. Look for low expense ratios as well as long-term performance history of at least five years. Use no-load funds rather than the Class A loaded share funds that Ramsey suggests on his website.

Some Simple Examples

Here are some suggestions if you want a nice shortcut:

An aggressive (high-risk) portfolio is good for investors who have time horizons of 10 or more years. They can hold on during periods of extreme volatility in the market.

A moderate (medium-risk) portfolio would work for investors who have time horizons of five or more years. They can only tolerate medium swings in account value.

A conservative (low-risk) portfolio is best for investors who have time horizons of three or more years. They have low tolerance for fluctuations in account value.

DISCLAIMER: The information on this site is provided for discussion only. It is not investment advice, and it is not a recommendation to buy or sell securities.