Last week, I discussed a key challenge in personal finance: that in a field where we would expect facts and logic to drive decisions, we instead find that misconceptions and misunderstandings often take hold. Last time, I outlined five common financial myths. Below are five more:
“When a company is doing well, its stock should go up.” Benjamin Graham, the father of investment analysis, was famous for the way he explained stock market behavior: “In the short run, the market is a voting machine but in the long run, it is a weighing machine.” In other words, stock prices don’t behave consistently. That’s a big part of what makes the market so maddening.
Let’s start with Graham’s weighing machine. Look at a long-term chart of a market index like the S&P 500, and you’ll see what he meant. Stock prices, over time, increase more or less in line with the profits of the companies in the index. It’s not a perfect relationship, but stock prices do weigh the facts fairly accurately.
Look at a chart covering a shorter period of time, though, and it’s a different picture. Sometimes stock prices follow profits, but just as often, prices seem to rise too high or fall too low. That’s because market sentiment—driven by the news of the day—often gets in the way of the tidy relationship between companies’ profits and their stock prices. In the short run, therefore, the stock market is more like a popularity contest.
The bottom line: You should feel good about investing in the stock market for the long term and never be discouraged by whatever irrational behavior it exhibits in the short term.
“I’ll earn more on a bond with a higher interest rate.” Suppose you’re choosing between two bonds, one that pays 3% and one that pays 5%. Which would you choose? The answer is that it depends what that 3% and 5% mean exactly. There are two interest rates that matter to a bond—its coupon rate and its yield—and it’s important to know the difference.
The coupon rate is the interest rate stated on the bond. If a coupon is 3%, for example, then a $1,000 bond will pay an investor $30 each year. A bond’s yield, on the other hand, is a function of three factors: the coupon rate, the price at which the bond is purchased and the time remaining until maturity. When these three factors are combined, the yield on a bond can end up being higher or lower than its coupon rate.
Consider a $1,000 bond with a 3% coupon and one year to maturity. Because rates on new bonds are closer to 5%, you’d likely be able to purchase this 3% bond for less than face value. Let’s say you can buy it for $980. What will you earn? The coupon is the easy part: That’s $30. But when this bond matures, you’ll earn another $20. That represents the $1,000 face value you’ll receive at maturity minus your purchase price of $980. Putting these two together—$30 plus $20—your total return will be $50. Since your purchase price was $980, your yield will be 5.1% ($50 divided by $980).
That 5.1% is known as a bond’s yield to maturity, and because it represents the total return an investor will earn, it’s the most relevant figure, in my view, for bond investors. In contrast, a bond’s coupon rate alone can be quite misleading.
“Life expectancy figures are reliable for financial planning.” Search online for the term “life expectancy in the United States,” and you’ll find these numbers: Males born today can expect to live to about 77, and women a few years longer. But those numbers are misleading because they refer only to the expected lifespan at birth. Morbid as it sounds, your own life expectancy increases over time as you outlive other people. As financial writer Jonathan Clements notes, this phenomenon applies to men in particular, who are more accident-prone during their teens and 20s.
The differences between life expectancy at birth and life expectancy later in life can be significant. Men who make it to age 65, for example, can expect to live another 17 years, to age 82—far longer than their life expectancy at birth. Women can expect to live almost another 20 years—to age 85. This dynamic is important to keep in mind as you make decisions that hinge on life expectancy—when to claim Social Security, for example, or whether to choose the survivor option on a pension or an annuity.
“Risk and return go together.” This view is so widespread that it’s virtually unquestioned. That’s for two reasons: First, it makes intuitive sense, aligning with the concept that “there’s no free lunch.” If an investor wants higher returns, he needs to “pay” for that privilege, and the way he pays is by assuming more risk. Similarly, if an investor wants to enjoy a less risky portfolio, it seems appropriate that he would have to “pay” for that security in the form of lower returns.
The second reason the risk-return relationship is accepted as an investment truism is because it’s a foundational element of Modern Portfolio Theory—a concept that’s earned multiple Nobel prizes. In his first paper on the topic, in the early-1950s, Modern Portfolio Theory’s creator, Harry Markowitz, drew a straight line to illustrate how risk and return were so clearly correlated. Later in the 1950s, William Sharpe, another key contributor to Modern Portfolio Theory, dubbed this the Capital Market Line. That helped cement the risk-return tradeoff in investors’ minds.
This tradeoff, however, is what comedian Stephen Colbert would call “truthy”—on the surface, it sounds like it makes sense, but on closer examination, it falls apart. That’s because risk is difficult to quantify. Consider two well-known companies: Apple and Amazon. Both are far ahead of their competitors. Their products are ubiquitous, and they have hundreds of billions in annual revenue. But as we’ve seen with other technology leaders, from Xerox to Polaroid to BlackBerry, no company is invincible. For Apple and Amazon, though, how could you possibly quantify that risk? My view is that it’s impossible. Risk simply can’t be distilled down into a number. And if that’s the case, then—despite the intuitive appeal—it’s impossible to try to quantify any connection between risk and return.
“Whole life insurance is an overpriced financial product and should be avoided.” The challenge with permanent life insurance products is that they tend to be weighed down by high costs and complexity. They can also carry tax consequences if they aren’t handled carefully. For these reasons, they don’t have the best reputation and aren’t, in my view, appropriate most of the time. But there are situations in which they can serve a purpose.
Suppose you’re the owner of a business large enough that it might trigger estate tax exposure when you pass. A whole life policy could help, allowing your children to pay the tax without having to sell the business. Another situation in which a business owner might want whole life coverage: if there’s a buy-sell agreement with a partner. The life insurance would be there to ensure the surviving partner could be bought out.
In short, permanent life insurance can help play a role any time a large lump sum is certain to be needed at the end of life, no matter how many years in the future that might be. That’s in contrast to term coverage, which is designed to protect against a different risk: an untimely death during a fixed period of time.
