Can a Post be Critically Important… and Deceptive?

Dave Ramsey is undoubtedly one of the most influential authors in the personal finance and FI/RE communities.  This “snowball” theory for getting out of debt alone is a classic.  One of his most quoted posts was back in 2010 regarding compound interest.  It was called How Teens Can Become Millionaires with the (summarized) following story.

Ben and Arthur are teenagers that want to retire rich at 65.  Ben starts investing early and contributes $2000 a year (only $166/mo!) to an S&P index fund from his 19th birthday to when he turned 26.  He then never invests another penny until he retires.

Arthur takes the more conventional investing route and doesn’t start saving until he is 27.  He contributes the same $2000 a year to an S&P index fund until he retires.

Ben contributes a total of $16,000 in his eight years of investing.  Arthur contributes $78,000 in his 39 years.

Oh, and here’s a super critical bit of information: let’s assume that they earn 12% on their investments.  When each retires at 65, who has more money?

Well, the post wouldn’t be titled “How Teens Can Become Millionaires” if Ben didn’t make out like a bandit.  Indeed, Ben’s $16K investment has grown to $2.3M while Arthur’s $78K has netted “only” $1.5M.

It’s no wonder this is such an influential post as it illustrates very dramatically the power of compound interest (compound growth).  Compound growth is one of the most critically important piece of knowledge for any investor to have and for that, this post deserves it’s accolades.

Yet… I have one serious problem with the post.  I think it’s unnecessarily deceptive.

A Digression

I got to thinking about this post again after a video by Mike and Lauren entitled Why Don’t They Teach This in School?. In no way is my own post a knock on their video. Mike and Lauren are one of the inspirations for this blog! I strongly recommend checking them out. Their point in the video is spot on.

And to his credit, Mike also mentions in the video that he disagrees with Ramsey’s post in his use of a 12% compound interest rate. So yeah, they’re off the hook completely!

The Deception

My core issues with Ramsey’s example is that his use of a 12% compound interest rate creates such unrealistic expectations that the concept of “compound interest” almost comes across as magic. I’ve heard that the rate is irrelevant, since it’s the concept that he’s teaching and that’s independent of any actual amount.

I disagree. Ramsey’s post is titled “How Teens Can Become Millionaires“, so the actual amount in question is crucial to his message. No “millionaire” and his post loses a huge amount of its punch.

The problem with 12% over 47 years is that it won’t happen. A far more realistic goal is 7%. I believe that there’s only been one (maybe two) times in the history of the stock market where 7% wasn’t easily attainable over any 30 year period.

So let’s use 7% as the compound growth amount but keep all of the other variables the same. When Ben retires, he now has $300K while Arthur has roughly $400K. We’re seeing a $2M reduction in earnings.

Oof.

$300K or $400K isn’t even close to millionaire territory. At 12%, Ben and Arthur can retire in comfort. At 7%… they better have a backup!

That’s why I consider the use of 12% deceptive. By explicitly referring to getting rich by doing barely anything, Ramsey is creating unreasonably false expectations on the power of compound interest. Knowing that diminishes his otherwise critically important point on the role of compound grown in investing.

Still Powerful!

Just because Ben is more likely to make $300K than $2,300K doesn’t invalidate the power of compound growth. Compound growth lets you double your earnings in only a few years, without doing anything on your part. It’s letting your money work for you, rather than you work for your money.

You can relatively accurately calculate how many years it will take your money to double by dividing 72 by your rate (the “Rule of 72”). That is, at 7%, your money doubles every 10 years (72 / 7 ~= 10). If you did magically get 12%, then it only takes 6 years (72 / 12 = 6).

And this compounds. Your money doubles again in another 10 years, meaning a 4x increase. And again in 10 years, meaning a full 8x increase. Ten years after that is a 16x increase. Powerful stuff indeed.

The only real problem with realistic interest rates is that the years are long enough that you won’t get rich if you only contribute small amounts of money. It does take money to make money. Compound growth isn’t magic!

Lesson learned: invest as much as you can as early and as often as you can. Contribute enough and when it doubles and doubles and doubles, then you’re talking serious amounts of money.