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Why Dave Ramsey is Wrong On Mutual Funds

How the Investment Strategy Can Hurt You and What to Do About It

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If you've been saving money, trying to get out of debt, investing in mutual funds or you just like listening to talk radio, Dave Ramsey needs no introduction. I was an early listener of his personal finance radio show (dating back to the mid-90's) and I own the first printing of his now famous book, Financial Peace, which remains on my shelf to this day. In fact, Dave deserves credit for helping me understand and enjoy personal finance, which eventually led to my career as an investment advisor. I am now a Certified Financial Planner (TM) and I own a fee-only Registered Investment Advisory firm. Of course, I am also your humble guide to mutual funds here on About.com.

This general respect of Dave Ramsey, combined with extensive financial services background and mutual funds expertise, makes me qualified to provide some insight into the best and worst of Dave's investment advice (although he's not licensed to sell securities and does not technically call it "advice").

What Dave Ramsey Gets Right

Dave's best value to his audience is that his message is simple, easy to understand and often entertaining. He also focuses on the psychology of money; Dave knows that an investor's worst enemy is often themselves.

In my experience, I know that if goals are not attainable and easy to understand, people fail early or they don't even make an attempt to reach a goal. This is true with financial goals, food diets, exercise programs and just about anything that requires motivation, time and patience.

Ignorance and the failure to act are often more dangerous behaviors in personal finance than applying less-than-ideal investment philosophies. Therefore, Dave's simple delivery and his "baby steps" to financial freedom are effective in pointing people in the right general direction than much of the complexity and noise in other parts of the financial services universe.

However, with regard to mutual funds in specific, Dave Ramsey's investment philosophies are bordering on dangerous. Mutual fund investors can get some good tips from his talk radio show but they are wise to understand the difference between entertainment and sound investment practices.

The Dave Ramsey Investing Philosophy

To be completely fair, let's begin with Dave's Investing Philosophy, specifically regarding mutual funds, taken directly from his website:

Dave recommends mutual funds for your employer-sponsored retirement savings and your IRAs. Divide your investments equally between each of these four types of funds:

  • Growth
  • Growth & Income
  • Aggressive Growth
  • International

Choose A shares (front end load) and funds that are at least five years old. They should have a solid track record of acceptable returns within their fund category.

If your risk tolerance is low, which means you have a shorter time to keep your money invested, put less than 25% in aggressive growth or consider adding a "Balanced" fund to the four types of funds suggested.

Poor Asset Allocation: Where's the Bonds?

One of the most fundamental aspects of asset allocation is to have more than one asset type. Dave Ramsey's 4-fund mix includes only one asset type; there are only stock funds, no bond funds or cash (money market or stable value). A portfolio consisting of 100% stocks is simply inappropriate for the vast majority of Dave's audience and, in the opinion of your humble mutual funds guide, an asset allocation of 100% stock funds is wrong for most human beings on the planet.

Dave's 4-fund Mix: Overlap Reduces Diversification

In the Dave Ramsey mutual fund investment strategy, he urges investors to hold 4 mutual funds in their 401(k) or IRA -- one Growth fund, one Growth & Income fund, one Aggressive Growth fund and one International fund.

This 4-fund mix has great potential for overlap, which occurs when an investor owns two or more mutual funds that hold similar securities. Following Dave's example, imagine an inexperienced investor looking at their 401(k) plan, which offers Vanguard mutual funds:

A common investment choice is Vanguard S&P 500 Index (VFINX). The beginning investor would not know if this fund was "growth" or "growth & income" or neither. Also, what if another choice in the plan was Vanguard Growth Equity (VGEQX)? At least the investor could guess this fund was "growth" but would the investor know if there was overlap? Here's how they can find out (although Dave might not tell them this). They (or you) can go to Morningstar.com and enter a search for VGEQX. Once on that fund's main page, look for a link to "Ratings and Risk" and click on it. When on that page, scroll down and you'll see something called R-squared and that it is 97. This means that VGEQX has a 97% correlation to the S&P 500 index fund; they are virtually identical!

Making things worse, an investor may understandably think any international stock fund won't invest in stock found in their domestic growth or growth & income fund. However, if the fund is cagtegorized as "world stock," it can invest anywhere between 20% and 60% in US stocks.

In summary, Dave's 4-fund mix could potentially have the same diversification as just one or two stock funds. If and when US stock prices fall, an investor's account value could fall much more than if they had a diverse mix of stock funds and bond funds. This kind of loss of account value is what frustrates investors and makes them stop investing altogether.

Where's the No-Load Funds?

In his investment philosophy, Dave says to use A shares (loaded funds), which means the investor will pay commissions to a broker or investment advisor (in an IRA or brokerage account). Why wouldn't Dave recommend no-load funds? My first guess is because Dave tells his listeners to use an "Endorsed Local Provider (ELP)". This is a broker or advisor that Dave recommends (although I suspect these ELPs also advertise on Dave's show). I wonder why he wouldn't help his audience invest for themselves or suggest using a "fee-only" advisor that can recommend no-load funds and only gets paid for the unbiased advice they give?

Dave's Definition of Risk Tolerance is Wrong

Dave says that investors may need to adjust the aggressive portion of the portfolio if their risk tolerance is low and he says risk tolerance "means you have a shorter time to keep your money invested." No, the amount of time is the investor's time horizon to the end of the investment objective or savings goal, which has nothing to do with risk tolerance. The true definition of risk tolerance refers to the amount of market risk, especially the volatility (ups and downs), an investor can tolerate. An 80-year old can have a high risk tolerance and a 20-year old can have a low risk tolerance. The amount of risk an investor can tolerate is completely about emotions or feelings, not an amount of time.

What Dave Ramsey probably means when he says risk tolerance is what I call "risk capacity," which is the amount of risk someone can "afford" to take. For example, even if you consider yourself an aggressive investor (high risk tolerance), it may not be wise to have 100% of your retirement savings in stocks just one year before you plan to retire. Likewise, if you have 40 years until retirement (long time horizon, high risk capacity) but you have low risk tolerance, you won't be served well by putting all of your 401(k) money in a stable value fund.

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