Eighteen months ago, I met a wooden boat guru named Ron. He taught me a lot about my wooden boat and why chunking — when you replace only the rotted sections of wood, rather than replacing the entire plank — is dangerous. If you do this, eventually you’re left with a boat composed of many small chunks of wood.
Before I met Ron, chunking seemed logical. Replace bad with good. Many sites on the Internet show how to chunk in simple, logical terms. A shipwright easily sees the flaws, but a greenhorn like me does not. I was a chunker.
Put in simple terms, Dave Ramsey’s investment advice, including his misguided information about bond allocations, sounds logical to those who don’t know much about investing — just as chunking sounds logical to a wooden boat novice until he gets a one-on-one dissertation on the eventuality of extinction caused by a chunking epidemic worthy of an Obama administration intervention.
Are bonds bad?
It’s Friday, July 10th, 2015. I’m 2 hours 31 minutes and 48 seconds into the Dave Ramsey Show. Kathy from Jacksonville, Fla. calls in to ask Dave what she and her 11 siblings should do with the approximately $700,000 of assets their mother and father have saved after selling their home. They now reside in an assisted living facility.
Before we dive too deeply into this, I want to highlight a few things Dave says to Kathy:
- “I’m not a fan of bonds.”
- “A growth and income [fund] is [a balanced fund’s] kissing cousin and is very conservative, too.”
- “These stupid bonds could go in half in value.”
- “Financial goober” (not really relevant, but it made me laugh)
- “I don’t like them, period.” (Referring to bonds)
- “I’d rather you sit in the money market than in bonds.”
Where to start? Financial goober, let’s start with that. Financial goober — funny, cool name. Thank you, Dave, for the laugh. Moving on. The statements “I’m not a fan of bonds” and “I don’t like them, period,” are absolutes. Are all bonds absolutely bad? What about James Bond? OK, Dave was referring to bonds not a bond, so what about Sean Connery, Daniel Craig, and Pierce Brosnan … all these Bonds are fan-worthy, right? Joking aside, later comments indicate that the foundation of Dave’s Blofeld-quality hatred toward bonds seems to be based on a limited understanding of their basic characteristics.
Dave tells Kathy, “If you’ve got the money in Fannie Mae bonds because some goober financial planner puts you in an asset allocation method, and interest rates tick up a quarter of a point or a full percentage point, your stupid bonds could go in half in value.”
Why that’s elementary, my dear Watson. Read almost any short blip about bonds and you’ll learn that there’s an inverse relationship between bond prices and interest rates, which Dave now says to Kathy. Yes. This is fundamentally correct. So Dave’s right, then, bonds are dangerous in a rising interest rate environment. But wait, I forgot something: Bonds contain market risk unless you hold them to maturity. In the case of Kathy’s parents, if the money isn’t needed for many years yet, individual bonds could be a useful resource … dare I say, a useful allocation.
Now, what about defined maturity date bond funds? I need to give you more details before we proceed.
Kathy’s parents are 84 and 90 years old. They’re spending about $4,500 per month on their assisted living facility, with another $500 per month on discretionary personal utility items. They receive about $21,000 per year from Social Security. In all, they spend approximately $60,000 annually. This means they’re going through about $40,000, or have a burn rate (as Dave calls it) of about $40,000. At this rate, their assets should last for about 10–15 years even without interest, due to the inflationary pressure on the assisted living costs.
Knowing this, Dave recommends the couple “invest some of it, use the stuff on the back end … the 8–15 year money.” According to Dave, they’re investing “in hopes [to] make more than 1 percent on it, like [they would in] a stupid CD.”
Apparently, CDs are stupid, bonds are stupid, asset allocation is stupid. Dave Ramsey would be the King of Wit in any elementary school classroom.
But let’s forget about the childish language. This is not personal. It’s business. Since we have a 10-plus-year timeline, individual bonds could be used, and it’s hard to imagine them not outperforming the money market. As mentioned, Dave told Kathy, “I’d rather you sit in the money market than in bonds.” While he understands the inverse relationship between bond prices and interest, he doesn’t consider the fact that, at maturity, bonds will pay back the par value (which may be greater or lower than the purchase price if not purchased at issue). A financial planner, one with the formal training Dave loves to cheapen, knows a bond held to maturity doesn’t have market risk. This isn’t because we’re financial snobs who demonstrate paralysis of the analysis, but because it’s a financial fact, widely known.
To prove it’s not personal, here’s a counterargument: Individual bonds held to maturity still have default risk, reinvestment risk, and market risk if liquidity is needed prior to maturity. I’ll get to that.
Dave Ramsey is either right about bonds, or he’s wrong. If he’s wrong, then he’s either dishonest or incompetent. (I tried to find a softer word, but the synonyms listed were inept, useless, bungling, unskilled, ineffectual, hopeless, inapt, and unable … none of which seemed nicer or more accurate.) I’m not saying that Dave is dishonest; he could be right or wrong and still be telling what he believes to be the truth. I wasn’t dishonest when I chunked instead of making a new plank. I was unknowingly negligent. I grew up around the remodeling and building industry and knew my way around some tools, so I figured I was equipped to work on a wooden boat. Dave assumes that since he gives advice about debt, and since he was once broke and is no longer broke, that he’s well suited to give advice on investments. Sadly, we both incorrectly identified a cause-and-effect relationship. I’ll get to the math to prove it.
Back to Kathy’s parents and their financial plan. Dave warns Kathy that, “These stupid bonds could go in half …” As we know, this is false if the purchaser holds to maturity and the bond does not default. I suppose we could argue that the inflation-adjusted value of the bond could decline to effectually make the future purchasing power of the asset half of its starting value. But this argument is specious. First, Dave doesn’t assert this. Second, it’s hard to assume this is what Dave meant considering that, up until his spat with a Motley Fool author, Dave’s site inappropriately used an average annual growth rate not adjusted for inflation rather than an inflation-adjusted compounded annual growth rate (CAGR) of the S&P 500. Third, even if Dave accidently meant that the inflation-adjusted value could be halved, we’d still have to see inflation of 9.33 percent for this fallacy to be a reality (assuming we had a 10-year bond with a two percent coupon rate, and the interest was reinvested at two percent). In case you missed it, this would be assuming all reinvested dividends are invested at two percent (despite the reality that prevailing interest rates are sharply rising) AND that inflation climbs north of nine percent. Seriously? Come on.
Is Dave right about bonds, or do his beliefs lie on the verge of unintended negligence? Before you conclude, we should discuss default risk. We can lessen the risk of default and the risk of selling the bonds at a discount due to unexpected liquidity needs if we use defined maturity date bond ETFs. In this scenario, the default risk would be lessened considering the ETF would be split among many companies and sectors. In addition, the risk of selling at a discount would be lessened by the use of shorter maturity dates.
Could these “stupid bonds could go in half in value”? Let’s use an example that equally invests one third into 2016, 2017, and 2018 maturity dates. What kind of “uptick” would we need to have to lose half? Although I think this is widely unrealistic, for fun, let’s assume a 40 percent default rate, and that the defaults trade at a 70 percent discount. The 2016 allocation has a 1.5 percent yield, and each additional year of maturity gains an additional .5 percent yield. For even greater enjoyment, none of the dividends or cash at maturity is reinvested. In three years, in order for Dave to be right, where an “uptick” causes these to be worth half their original value, inflation would need to be over 13 percent.
Seriously, Dave? An uptick of one percent could potentially cause the value to drop by 50 percent if we were purchasing bonds with greater maturity or bond funds with longer duration, but it’s highly unlikely for this to translate into the truth Dave painted. It becomes even more unlikely with just a few minor adjustments to the strategy laid out above.
The distance between insanity and genius is often small. It is clear that Dave’s assertion that these “stupid bonds could go in half in value,” is misguided and half true at best. And, we haven’t even touched the fact he said a “growth and income [fund] is [a balanced fund’s] kissing cousin and is very conservative, too.”
Dave proclaims that both of these vehicles are very conservative. Here’s the problem. I can’t define what Dave means by “very conservative.” I will, however, share with you what I think “very conservative” means. I believe “very conservative” would be something with minimal chance for loss of principal. A conservative investment can lose money, but is stable and unlikely to experience double-digit losses.
Many readers favor low-cost, no-load funds, while Dave recommends Class A shares with a load. For the no-load we’ll use Vanguard, and for the A shares we’ll use American Fund. Let’s see just how much each came down from their peak in the 2007–2009 era.
I used Vanguard’s Growth and Income (VQNPX) and Balanced Index (VBINX), as well as American Funds Balanced (ABALX) and one of their Growth and Income (AMRMX). They each lost anywhere from 25–45 percent in their peaks. The Vanguard funds were ranked, by Vanguard, as 4 out of 5 and 3 out of 5 percent on a risk/reward scale (with 5 being the most risky). I would expect something “very conservative” to not be in the middle or in the upper half of the risk-reward spectrum — but, hey, that’s just me.
American Funds were a bit better, but they didn’t have the same rating category as Vanguard and there were multiple growth and income funds to choose from. On the plus side, these funds were mostly in the lower volatility, lower return quadrant, but this doesn’t change the fact they still came down nearly 25 percent. Is this VERY conservative? I say, no. It is not.
Another example of a half-correct answer from Mr. Ramsey occurred on September 4th, 2015. Dan from Alexandria, La. asked where to invest short-term dollars designated for a home purchase in about five years. Dave advises Dan to purchase an S&P 500 index fund, saying, “When you’re looking ahead five years or more, you have a pretty good safety mechanism to be in good growth stock type mutual funds,” since “the vast majority [of the five-year periods], upward of 80–90 percent, make money.” He says that you could lose money “but it wouldn’t be substantial, very minimal” and that “even if the market were down, you could wait six months and ride it back up.”
While this is once again fundamentally true, it’s also misleading. Many followers won’t realize that Dave means that if your $80,000 down payment grows to $110,000 and then dips back to $75,000, you might only have to wait a few months for your investment to return to $80,000. We’re not talking about waiting for it to get back to $110,000 here. There is still a meaningful loss during the investing period.
Basic financial principles
These types of errors occur when we abandon the basic principles of financial products. In previous columns, we’ve been critical of Mr. Ramsey’s usage of the term “investing advisor,” as this term does not exist and is therefore misleading. Recently, I noticed while listening to his show that Dave didn’t refer to his trusted legion as “investing advisors” but as “investing endorsed local providers.” I commend Dave for this change. But it got me thinking. If he’s wording it differently on the radio, has he also changed his website? As I was looking for confirmation, I ran across this page, which states, “Over the lifetime of an investment, a commission-based fund will cost the least.” End of paragraph. The next paragraph says, “Hiring an investment advisor is a wise decision.”
I absolutely agree with Dave. Hiring an investment advisor IS a wise decision. Only one problem: I guess Dave doesn’t know that investment advisors are prohibited from using a commission-based fund?
I remember the first spot of rot I found on my first wooden boat. What seemed to be a foot of rot turned into about six feet, and I chunked it, unknowingly creating a weak spot. I grew up around construction. I thought I knew what I was doing, and logically thought the boat was better off for it. Dave’s knowledge of bonds is clearly as sophomoric as was my knowledge of plank replacement. Remember, Dave is not licensed. In one moment, he tells his readers to work with a commission-based advisor; in the next, he unknowingly tells them to work with an advisor who’s prohibited from working in that capacity. Dave warns 8.5M listeners that with an uptick of 1 percentage point “stupid” bonds could be halved in value. Either through ignorance or deception, he ignores simple strategies that would diminish the probability this would happen. I guess it’s just … shocking. Positively shocking.
As always, thanks for walking down this path with me. If you see something you’d like us to address from American’s “Favorite” finance coach, please email my editor at firstname.lastname@example.org.