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.