EARLIER THIS YEAR, before the coronavirus hit, my family visited an amusement park. Everyone had fun—except my nine-year-old, who complained about the injustice of the rigged “down the clown” game.
You have probably seen this sort of thing: You’re given a handful of baseballs. Then, standing from about 10 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 aren’t that 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, which made them difficult to throw, let alone hit anything.
In the financial world, few things are such obvious frauds. But the phony baseballs got me thinking about some of the financial “truths” that we hear repeated so often that they’re regarded like laws of nature. Here are five such truths—all of which, in my opinion, we ought to question:
1. Modern Portfolio Theory. In 1952, 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 not only a new idea, but also a good one.
A central tenet is the idea that an investment’s risk can be distilled into a single number. This notion is attractive for its simplicity, but it’s flawed. How so? It rewards stocks with stable share prices and penalizes those with prices that bounce around a lot.
While this seems logical, consider how it might apply in practice. Over the past five years, Amazon’s share price has soared 468%, while one of its hapless competitors, Macy’s, has seen its stock sink 92%. But according to Modern Portfolio Theory, Macy’s is less risky than Amazon—because Macy’s stock has deteriorated slowly and steadily, while Amazon’s stock has moved up quickly. To me, this makes no sense.
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.” Commentators love to talk about it, especially when it spikes higher.
But there are two reasons I wouldn’t worry too much about the VIX. First, it’s just a measure of market volatility. It doesn’t say anything about returns. Second, even when it comes 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.
Earlier this year, for example, just before the coronavirus hit, the VIX was near historic lows. There was no indication that the market was about to go off a cliff. As a peer once quipped, “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 what about the Nobel prize for economics? It isn’t an actual Nobel Prize and it isn’t awarded by the Nobel committee. It was created 75 years after Alfred 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 both won. Bottom line: In economics, the prize’s imprimatur 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 in 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.
Sound attractive? Before you go down this road, remember that tax-deferred doesn’t mean tax-free. After age 72, you’ll have to take money out of your retirement accounts, at which point it will be subject to prevailing income tax rates. 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.
5. Social Security. Google the phrase “Social Security insolvency” and you’ll turn up 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. Does this mean the program will stop paying benefits? That’s more fear mongering than fact. There are lots of ways to fix the system. While Congress is often dysfunctional, Social Security affects constituents in both parties, so I’m confident they’ll work something out. No, Social Security isn’t going bankrupt.
Adam M. Grossman’s previous articles include No, I’m Better, A World of Problems and Thinking It Through. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.
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