I was going through a very popular book on personal finance (Dave Ramsey’s Financial Peace Revisited) and the author makes an assumption that concerned me.
I should preface this by saying that Dave Ramsey has done some excellent work helping people pay off debt and live much more financially-responsible lives.
So what is this assumption? He assumes investments will grow at an average rate of 12% per year. When I’m helping people with their finances, I assume a worst-case scenario and assume about 8.5%.
I decided to examine the returns of the Standard & Poor’s 500 Index. This is an index of the stocks of the largest 500 companies traded in the United States. I looked back to the earliest date possible, 1926.
What I found was that from 1926 through 2008, the average annual return was 9.8%.
Then I looked at all of the 40-year periods in this time (there are 44 40-year periods) and the average annual return of those periods was 11.1%.
Finally, I looked at all 25-year periods between 1926 and 2008 (there are 59 44-year periods) and the average annual return was 11.7%.
What does this all mean?
A difference between the 11.1% earned in the average 40-year period and the 12% Dave Ramsey assumes may not seem like much, but let’s say you invest $200 per month for 40 years at 12% and your friend invests at 11.1%. You would have just over $1.8 million and your friend would have about $1.44 million.
If you keep all of the numbers the same but change the time period to 25 years, you would have $320,000 and your friend would have $278,800, a difference of $41,000 or 14%.
How this changes how you save
Many people look at these numbers and say, “Well, there’s nothing I can do about it. I may as well invest and hope for the best.” That’s a very understandable position to take. Unfortunately, many people say, “Well, I’ll invest with the assumption of getting 12%.”
So let’s say you’re 40 years away from retirement and you decide you need $1.8 million when you retire. If you invest $200 per month and you only earn 11.1%, you will come up short. If you had invested $250 per month and figured you would only earn 11.1% you would reach your goal of $1.8 million in 40 years.
What to do about it now
As many of you start to pay off debt and begin to invest for future goals, sit down and think about whether it makes sense to stretch a little and invest a bit more each month in case your investments don’t earn this hypothetical 12% each year.
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