July 15, 2009

Dave Ramsey's Overly Optimistic College Investment Growth Expectation

The other day I was watching an older episode of the Dave Ramsey show. In one bit a caller asked about saving for college. Dave's advice to the caller was to open an Education Savings Account (ESA) and put $2,000 a year into it. He said that after 18 years of investing over a childs life you'd accumulate over $120,000. I'm paraphrasing here since I didn't capture the exact quotes. But I remember for sure he was claiming about $90,000 in growth in the investment over the 18 years with $2,000 annual contributions. I did a little math in Excel and checked it with this investment calculator and it appears that Dave is expecting 12% growth in the college savings investments.

I have 3 problems with Dave's advice.

1. I don't know why you'd want to invest in an ESA over a 529 in general. 529 savings plans are newer than ESA's and have a lot of benefits over them. Moolanomy discussed Dave's recommendation of an ESA over 529 and disagreed. Motley Fool also compares the different college savings plans. I do think that sometimes a 529 isn't the best choice especially if your state has a poorly designed one with no tax perks. But in my opinion for most people the 529 should be the better investment option. Dave Ramsey does discuss ESA's or 529's as options on his website. But he seems more in favor of ESA's than 529s due to their flexibility.

2. I think that 12% return expectation is overly optimistic expectation. If you're investing for 18 years its likely you'll hit a good rate of return over so many years. But 12% is pretty optimistic expectation. This post at Get Rich Slowly has some charts on historic stock returns. Using those charts as a reference, historically the S&P 500 had about a 80% chance of hitting 12% returns over a 15-20 year period. So then there is a 1 in 5 chance you'll have had lower than 12% annual returns. If you aimed for a lower 8% return then you would hit that 100% of the time for every 15 or 20 year period in the S&P 500 history. I think you should hope for 12% but expect 8% over a 15 year period.

3. You wouldn't want to be 100% in the stock market 100% of your saving period. Dave's prediction on the investment growth is based on investing your entirely money in the stock market. But what if the stock market has a down period in the 1-2 years just before college starts. If you started investing in stocks in 1992 and your child was just about to go to college this year and you still had all your money in equities then you would have seen your college savings drop about 40% in the past 12 months. Of course 2008 is an unusual year for stocks, but for an individual 1 year period theres a fairly decent probability that stocks will lose money. I wouldn't risk it. To be safe, the closer you get to the end of your savings period, the less you should have in stocks. It would be safe to start shifting your college savings over to bonds and/or cash around 5 years before college starts. That would mean 13 years investing 100% in stocks and then 5 years investing in bonds and a gradually decreasing % of stocks. An impact of safer allocation between stocks and fixed income would be lower investment growth. While you might get 8-12% annual growth while you're 100% the stock market for the first 13 years, during the last 5 years when you shift the % allocation over to fixed income your growth rate will be closer to 4-8% due to lower returns from bonds and cash.

Bottom line:
Of course Dave's basic advice is to put $2,000 a year into an ESA isn't a bad idea really. An ESA is a decent way to save money and saving $2,000 a year is a decent goal. However I think setting expectations too high such high investment growth is not good idea and can leave some people with a false sense of security. And for most people the 529 savings accounts are going to be a better option.

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