3 Investment Myths Busted
February 26, 2015Think you know everything you need to know about investing? I recently read three articles that dispel some conventional wisdom when it comes to your investments. Here are the busted myths along with the implications of what they could mean for you:
Myth #1: You can expect 10% average stock market returns. This have been the long run historical average and many financial plans use this as an assumption.
Busted: In “The investing golden age may be over: Robert Shiller,” the Nobel-prize winning economist and Yale University professor is quoted as saying that he doesn’t believe that the historical 10% average returns will continue to be true because stocks are priced pretty high relative to various measures of valuation and these high valuations have consistently led to lower returns in the past. With interest rates near zero, bonds can be expected to return less as well.
What it means: Shiller recommends making up the difference by saving more than the current 5% average US savings rate. What he doesn’t say is how much more. Instead of assuming 10% returns in the stock market or even 8% for a balanced portfolio of stocks and bonds, use returns in the 4-6% range (depending on how aggressively you invest) when calculating how much you need to save for long term goals like retirement or education expenses.
This may mean reducing your spending (Shiller recommended that his students continue a student lifestyle after they graduate to build up their savings) or just slowly increasing your savings rate over time. If Shiller’s right, you should still be able to achieve your goals. If returns end up being higher, you’ll have earned that higher return on more savings and no one has ever complained about having too much money later in life. Either way, you win.
Myth #2: Rising rates will devastate bonds. When interest rates go up, bond prices fall.
Busted: In “Here’s the income portfolio you want to own when interest rates rise,” Mark Hulbert points out that when interest rates nearly tripled from 1966-1981, a portfolio of US treasuries with a constant maturity of 5 years earned an annualized 5.8% return, almost as much as the 5.9% annualized return of the S&P 500. That’s because falling prices were offset by the rising interest income.
What it means: Don’t be afraid of owning bonds as a way to reduce risk in your portfolio. However, keep in mind that this was based on bonds with a 5 year maturity. Longer term bonds are affected more by rising rates and may not hold up as well so you might want to stick to short and intermediate term bonds.
3) Myth #3: All index funds are created equal. It doesn’t matter which index fund you pick as they all just track the market with low expenses.
Busted: “Trouble in index city” illustrates just how much variance there are in index funds. Some charge high fees like the Rydex S&P 500 index fund C shares, which cost 2.3% a year for essentially the same investment that you could buy for less than a tenth of the price elsewhere. Others, like the Rydex S&P 500 2x Strategy fund, aim to double the losses and gains of an index with futures and/or options. If the S&P 500 does well, why not do twice as well, right? Well, it didn’t quite work out that way. The Rydex fund only gained 92% vs. the 108% by the Vanguard S&P 500 Index fund over the last decade because the big gains weren’t enough to make up for the even bigger losses. Finally, not all index funds stick to the S&P 500. Some are inverse, meaning they rise when the index falls and vice versa. Others are specialized in certain sectors or other countries or are based on mid or small cap stocks. A new breed of “index” funds even weight stocks equally or by “fundamentals” like dividends or only include stocks that buyback shares or that have exhibited low volatility.
What it means: Don’t just buy a fund because it has “index” in the name. Like with all investments, make sure you understand what you’re investing in.
Save more. Invest in bonds to reduce volatility. Understand what you’re investing in. Maybe you do know what you need to know about investing. As they say, the more things change, the more they stay the same.