Be Careful Where you get your Financial Advice from….

You have to be so careful getting your financial advice from entertainers and people who put themselves out there as “financial experts” (I do that also and you should be damn skeptical of everything I write).  I got to thinking about this as I read this post on Dave Ramsey’s website about asset allocation.  Here is the question from a listener of Dave’s show and his subsequent answer:

Dear Dave,

Can you explain the “asset allocation” theory when it comes to investing?

Matthew

Dear Matthew,

The asset allocation theory is one touted by lots of people in the financial community. It’s also a theory with which I disagree.

In short, the asset allocation theory means that you invest aggressively while you’re young. Then as you get older, you move toward less aggressive funds. If you follow this theory to the letter, you’re left pretty much with money markets and bonds by the time you’re 65.

The reason I don’t believe in this theory is simple. It doesn’t work. If you live to age 65 and are in good health there’s a high statistical likelihood that you’ll make it to 95. The average age of death for males in this country is now 76, but that includes infant mortality and teenage deaths. So, a healthy 65-year-old man in America can look at having another quarter century on earth. If you move your money to bonds and money markets at age 65, inflation is going to kick your tail. Your money will grow slower than it will devalue, and you’ll have little purchasing power. That’s the problem with the asset allocation methodology.

I advise investing in good, growth stock mutual funds  that have strong track records of at least five to ten years. Spread your money across four types of funds: growth, growth and income, aggressive growth and international. These groups provide diversification across risk, as well as a little splash overseas.

Great question, Matthew!

—Dave

Poor Matthew.  I sure hope you didn’t take this advice to heart because it’s pure nonsense.  There’s so much wrong I don’t even know where to start…

First, “asset allocation” isn’t a theory that any reputable financial expert rejects.  It’s about as close to a law of finance as it gets.  The idea is extremely simple.  By owning the market portfolio of financial assets you reduce unsystematic risk.  That is, owning a slice of the market portfolio exposes you to company or entity specific risk.  By owning a broader swath of the outstanding financial asset portfolio you reduce the risk of being exposed to an Enron,Lehman Brothers or Greek style collapse.  Again, this isn’t a theory.  It is a basic understanding of modern finance.

Second, you don’t own bonds to beat inflation.  I think this is a case of Dave’s politics getting in the way of sound thinking.  Bonds provide investors with a fixed income stream and embedded guarantees.  This reduces the volatility in the returns of the instrument and provides the investor with greater security. Over the history of the bond market, bonds don’t tend to outperform inflation by much.  The inflation adjusted return of a 10 year T-note is about 2%.  Not exactly a great inflation fighter.  But that’s not why you should own bonds.  You own bonds because they provide stability in your portfolio.  They counteract the volatility of instruments like stocks and help you smooth the total portfolio return.  Most of us don’t want to expose our financial assets to the stock market rollercoaster ride because that creates uncertainty and instability in our personal lives.  Bonds are one form of instrument that helps us generate an income for our savings without jumping on that rollercoaster.

Lastly, the idea that you should just own stock mutual funds is horrible advice.  Various studies show that past performance of mutual funds is a poor predictor of future returns.  In addition, most mutual funds charge very high fees despite regularly underperforming index funds.  And owning nothing but stocks doesn’t diversify the risk of stocks away.  In fact, it just exposes you to the aforementioned rollercoaster ride.

No wonder Americans lack basic financial literacy.  Even some of the experts lack basic financial literacy….