On the Newhart TV show there appeared two semi-regular characters who spoke in a thick New England accent. I clearly recall a scene where Newhart is describing a rather tame course of action in his deadpan voice which prompted one of the guys to say, “Idunno. Sounds Risky, Bob.”
I’ve also heard a lot of personal finance guys bitterly complain about Dave Ramsey and how his advice does not make sense mathematically. Recently, I was able to put together these two seemingly disparate factoids. Here’s how…
Consider an example where we’ll likely hear Dave Ramsey’s “bad” advice: You can get an 11% return in a stock market index fund such as VTSAX. As of this writing the year-to-date return is 13.95%. Don’t take my word for it. Check out VTSAX for yourself. Conversely, rates on a 15-year fixed rate mortgage are running TEN PERCENT less. This is freaking huge. If you own your house free-and-clear, you could refinance $200,000 of it at 3.95%, put that money into VTSAX and the difference between what you’d pay in mortgage interest and what you’d get in investment gains would be almost $20,000/year!
That’s $20,000 you don’t have to work for. Just file some paperwork with the bank and boom. That’ll buy a lot of catfood.
Why doesn’t Dave Ramsey tell everybody to do this? He must be an idiot and a fool unaware of simple finance! He must hold some vindictive grudge against banks! You should listen to me instead and get your $20,000. Anybody who knows the first thing about real estate can tell you that you get rich using leverage–OPM–Other People’s Money! Ramsey doesn’t know the first thing about real estate!
Of course I believe nothing of the sort.
“Idunno. Sounds risky, Bob.”
There is one thing everyone must understand about insurance. Insurance is always a bad deal. We all want to go through life without any visits from the mayhem insurance guy. You pay out premiums and get nothing for them, but the worried-about hazard never happened. Insurance is a bet between you and the company that a bad thing won’t happen. You only win the bet when you lose in life.
This is what makes me grumpy at my coreligionists who condemn gambling. Gambling is always a bad deal, too. But it is an inevitable aspect of responsibly dealing with risk. Do not forego life insurance because it’s a form of gambling, but don’t lie to yourself about what you’re doing, either. The same goes for other forms of gambling, such as futures, Bitcoin, or market speculation. But I digress.
Risk explains Dave Ramsey’s so-called “bad” advice.
With statistics you can calculate the expected payoff of a bet by multiplying the size of the wager times the probability of winning. Let’s say we toss a coin and you bet $1.00. Your probability of winning is 0.5, thus the expected win is $0.50. This dollar amount will help you decide whether to take the bet or not. Just compare the expected payoff with the promised payoff.
Insurance companies do this when they underwrite a life-insurance policy. They calculate the probability of you dying and if you are young and healthy, they ask for a lower premium. Conversely, if you’re old and sick, they boost the premium amount. They win-some, they lose-some, but over time and many policies they make money.
Risk dictates what the insurance companies charge for premiums. Since these companies are in business to make money, they charge enough to cover risk plus give their shareholders some profits. But first they have to assess risk. Particularly, they have to quantify risk.
Quantifying risk is hard. You need a stastistically significant number of data about the hazards insured against. And you need significant math-fu to crunch that data. Before my successful career writing software, I was tempted to become an actuary. Actuaries are professional math geeks who look at all the data associated with accidents, health-expenses, and mortality to figure the odds of various hazards. With these probabilities in hand, they can recommend whether to offer insurance products and how much to price them.
Risk tends to be invisible. Dave Ramsey was blind-sided by invisible risk. He had leveraged a lot of OPM and built a fortune. This fortune was destroyed when the unforeseen risk of banks calling his loans came all at once. He was put into the position of being forced to sell. When he sold at a disadvantage in a really bad market he suffered major losses.
(My great risk of owning so much VTSAX is the possibility I will be forced to sell in a down market. I have no plans to do so nor do I foresee anything that will force my hand. If I do foresee something like that, I intend to insure against that contingency.)
Now, let’s return to the example I started with. Suppose I mortgage my house to buy a bunch of VTSAX. I just promised $20,000 a year. If every year is like this one, all is well. But what if a black swan flies into Wall Street? How can I pay off that big mortgage? And how will I buy catfood without selling my precious VTSAX at a low price? This is risk. It’s an unacceptably high risk. Is it worth $20,000 per year to avoid it? Yup.
Dave Ramsey gives advice that seems to be bad mathematics, but he does so because most of the people he advises are neither actuaries, securities analysts, nor insurance underwriters. Instead of taking on risks we cannot quantify and don’t really appreciate, Mr. Ramsey shouts, “Stay Away!”
People safely handle high voltage lines all the time. But the power companies run ads on the radio telling everyone to stay away from downed power lines. Are the power companies stupid? Don’t they understand electricity?
No, they send out technicians who have the benefit of specialized training and protective gear. The training and gear enable these folks to handle high voltage lines at minimal risk.
Every instance of “bad math” that I’ve heard Dave Ramsey talk about corresponds to some aspect of risk. The debt-snowball vs debt-avalanche ecommendation engages the risk of a relapse to bad spending habits. Staying out of debt engages the risk of changing financial circumstances. Budgeting every dollar engages the risk of being caught unawares when expenses or income change.
Mr. Ramsey understands insurance and he advises people to get it, but only after shopping for the best deal, and only if they cannot afford to self-insure. However, self-insurance requires a stash of cash equal to the hazard and an awareness of the risks one is taking on.
Does it make sense to educate oneself about risk and how to quantify it? Yes. If only to know when to insure and how to judge between insurance offerings. Does it make sense to borrow against your house to buy into a hot stock market?
Idunno. Sounds risky, Bob.