A few days ago, my family visited an amusement park, and almost everyone had fun. Almost everyone—except my nine-year-old, who is still complaining about the injustice of the rigged “Down the Clown” game. You’ve probably seen this sort of thing: You’re given a handful of baseballs. Then, standing from about ten feet away, the challenge is to knock down as many mechanical clowns as possible for a chance to win a prize. It doesn’t appear difficult—you’re not far away, and the clowns are tightly spaced—but most people walk away empty-handed.
What’s the catch? Why is it so hard to knock down the clowns? In my son’s opinion, it was the baseballs. In every way, they looked legitimate—same size and shape, same white leather and red stitching—but they weren’t. They felt hollow and nearly weightless. This made them difficult to throw, let alone hit anything.
In the world of personal finance, few things are such obvious frauds. But these phony baseballs got me thinking about some of the financial “truths” that we hear repeated so often that they are regarded like laws of nature. Here are five such so-called truths that are, in my opinion, worth questioning:
1. Modern Portfolio Theory: In 1952, a fellow named Harry Markowitz introduced a new, statistical approach to building investment portfolios. This approach came to be known as Modern Portfolio Theory, and because of that name, people continue to view it as a new idea, and a good idea. But here’s my concern: A central tenet of this theory is the idea that the risk of an investment can be distilled into a single number. This notion is attractive for its simplicity, but the flaw is that it rewards stocks with stable share prices and penalizes those with prices that bounce around a lot. While this might seem logical, consider how it would apply to a real world case today: Over the past five years, Amazon’s share price has risen 466%. Meanwhile, one of its hapless competitors, Macy’s, has seen its share price sink 74% over that same time frame. But according to Modern Portfolio Theory, Macy’s is less risky than Amazon. Why? Because Macy’s stock has deteriorated very slowly and steadily, while Amazon’s stock has moved up quickly. To me, that’s completely illogical. For that reason, this theory is an investment “truth” that deserves a wary eye.
2. The VIX: Listen to the financial news, and you’ll undoubtedly hear about the VIX, a statistical measure of investor sentiment. It’s often referred to as the market’s “fear gauge.” For that reason, commentators love to talk about it, especially when it spikes up. But there are two reasons I wouldn’t worry too much about it: First, it’s just a measure of market volatility; it doesn’t say anything about returns. And even with regard to volatility, the VIX can’t predict too far into the future. For the most part, it just extrapolates from today to tomorrow. The VIX knows nothing about what will happen further down the road. As a peer once put it, “The VIX Index is one of those things people mention to sound smart.”
3. Nobel Prize winning research: For the most part, work that has passed muster with the Nobel committee is worthy of respect. But when it comes to economics, it’s important to keep in mind the following: First, the prize in economics isn’t an actual Nobel Prize and isn’t awarded by the Nobel committee. It was created 75 years after Nobel’s death and just borrows his famous name. In the words of a Nobel family member, it was a “PR coup by economists to improve their reputation.” One incident, in particular, illustrates why investors shouldn’t put too much stock in this prize: In 2013, there were three winners in economics. But what was odd was that two of them were antagonists, with exactly opposite theories. And yet they both won. Bottom line: In economics, at least, the imprimatur of this prize means only that the research was deemed innovative, and not necessarily that it was correct. It certainly shouldn’t be seen as an endorsement of any particular investment theory.
4. Retirement accounts: If you’re earning a high income, and especially if you live in a high-tax state, it’s natural to want to stash as much as possible into retirement accounts to defer taxes. If you’re self-employed, you may have even considered a cash balance plan, which might allow you to save $200,000 or more, per year, in tax-deferred accounts. To be sure, this sounds attractive. But before you go down this road, remember that tax-deferred doesn’t mean tax-free. After age 72, you will have to take money out of your retirement accounts, and then it will be subject to tax at whatever rates are in effect at that time. And while most people assume their tax rate in retirement will be lower, this is just a rule of thumb and not a guaranteed truth. The Federal budget isn’t in great shape, so it’s possible that someone with substantial retirement assets might end up paying a rate higher than today’s top tax bracket. It’s worth doing some math to explore this question.
5. Social Security: Google the phrase “Social Security insolvency” and you’ll turn up some worrisome commentary. Most frequently cited is the estimate, from the Social Security Administration itself, that the trust fund used to pay benefits will run dry in 2034. But does this mean the program will stop paying benefits? No, that is more fear-mongering than fact. There are lots of ways to fix the system, and though Congress is often dysfunctional, Social Security affects constituents in both parties, so I’m confident that, with fifteen years to go, they’ll be able to work something out. Social Security isn’t going bankrupt.