But maybe this is all one huge misunderstanding. Could Ramsey simply have been mistaken about his math? We all make mistakes, after all.
Nope. Not at all.
Last year, the financial giant Dave Ramsey was bested on his own show. Amazingly, this got very little press coverage and yet this one single interview has huge implications for both Ramsey and many of his followers (not to mention the financial planning industry). The guest? The Motley Fool’s Brian Stoffel.
Let’s set aside, for a moment, all of Stoffel’s lesser qualities. No, he hasn’t been a finance writer for very long. He doesn’t have a finance degree. He doesn’t have the “clinical” experience of working with clients. He doesn’t even have experience being interviewed by giants like Ramsey. That actually makes the interview even more stunning. Stoffel has beaten the giant of faith-based financial planning, and he wasn’t given the recognition he deserves. In case you missed it, here is the interview where Stoffel confronts Ramsey about his infamous 12 percent math.
The fundamental issue is math honesty
Ramsey tries to make the issue about saving money and motivating people to do the right thing. However, the issue is, and always was, about the math involved — specifically, honesty in math. And if you’re in the financial planning business, you had better be concerned with honesty, especially when it comes to averages.
The arithmetic mean vs. geometric mean debate
This is one of the most under-appreciated and under-analyzed aspects of financial planning. It’s rare that you see anyone talking or writing about this at all. Yet, it’s one of the most important things to get right when you’re offering financial advice, especially investment advice. The arithmetic mean is just the simple averaging of numbers. So, for example, if you have the following investment returns:
+20 percent -20 percent +10 percent -4 percent +5 percent +8 percent
The arithmetic mean is 3.167 percent. This is the average rate of return, and it’s what many financial professionals still use when discussing investment returns. Oddly enough, you can even find this kind of math being used in life insurance (and other) illustrations.
It gives you a simple way to calculate the investment return of a particular financial product, but it’s not terribly accurate. Why not? Because it does not correspond to reality.
Rates of return are representative of actual dollars and cents. They are a sort of “pre-knowledge” in that sense. When you average the growth rates in, say, the S&P 500 and calculate it as a simple average return over a specified number of years, you’re only getting information about the percentage rate involved, not the underlying monetary value that that percentage rate represents.