Financial Mathematics Text

Wednesday, December 19, 2012

Dave Ramsey and Asset/Liability Matching

While I don't personally follow Dave Ramsey's advice, I do occasionally read his column in the Sunday paper. In spite of that, generally I think it's good advice and more people would do well to follow it. With private debt levels at very high levels right now, especially household debt, it makes sense to take a close look at how we use debt and whether or not its appropriate.

His most recent post gave me pause for concern though. A family has some money saved in a mutual fund for their son's college tuition. Dave recommends keeping the money there "until right before you write the checks." His rationale is that he returned 16% last year and he's hoping to get at least another 10% this year.

This is not sound advice. The reason comes down to asset/liability matching.

Stock returns are quite volatile. And it's easy to lose money year over year. Using Robert Shiller's data, 1Y returns for the S&P 500 were negative about 29% percent of the time. If you look at 10Y returns, then returns were only negative about 3% of the time. In other words, the shorter the time horizon, the more likely you'll end up with negative returns.

In your life you'll need cash for various things: college tuition, down payment on a house, children's education, retirement, etc. Basically you need to assess how much money you'll need and when you'll need it. Then you'll need to choose assets whose time horizons match your money needs. Here's some examples:

Example 1: You're 30 years old and you plan to retire in 30 years. So your time horizon is 30 years. In this situation stocks and long-term bonds make sense.

Example 2: You're planning a vacation for one year from now. So your time horizon is 1 year. Here you don't want to use stocks and long-term bonds. You want to use savings account, money markets, and short-term bonds (less than 1 year maturity).

Example 3: You're 60 years old and you plan to retire in a couple of years. Here a good mix of shorter terms bonds (with perhaps some long-term bonds) might be more appropriate. Your stock holdings should be pretty small at this point.

Now obviously the retirement examples are more complicated as you don't need all that money at once. And an eye for which assets are offering the most attractive returns, relative to their risk, is important as well.

But if you're like the family in Dave's column and you need money in 2 years for your kid's tuition, then you should be in savings, money markets and short-term (high quality) bonds, not the stock market. It's too short of a time frame for when you need the money.

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