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LAST WEEK, I DISCUSSED a key challenge in personal finance: In an endeavor where we’d expect facts and logic to drive decisions, we instead find that misconceptions and misunderstandings often take hold. In my previous article, I outlined five common financial myths. Below are five more:
1. “When a company’s 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, share 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 corporate profits. It’s not a perfect relationship, but share prices do weigh the facts fairly accurately.
Look at a chart covering a shorter period of time, however, 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, 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 the short-term irrational behavior that it sometimes exhibits.
2. “I’ll earn more on a bond with a higher interest rate.” Suppose you’re choosing between two bonds, one that pays 3% and another that pays 5%. Which would you choose? The answer depends on what that 3% and 5% represent. 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. Put these two together—$30 plus $20—and your total return would be $50. Since your purchase price was $980, your yield would be $50 divided by $980, or 5.1%.
That 5.1% is known as a bond’s yield to maturity. Because it represents the total return an investor will earn, it’s the most relevant figure for bond investors. By contrast, a bond’s coupon rate can be quite misleading.
3. “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 age 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 HumbleDollar’s editor 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, such as when to claim Social Security or whether to choose the survivor option on a pension or an annuity.
4. “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: 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 it falls apart on closer examination. 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, how could you possibly quantify this risk? My view is that it’s impossible. Risk simply can’t be distilled down to 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.
5. “Whole life insurance is an overpriced financial product that 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 taxes when you die. A whole life policy could help, allowing your children to pay the tax without having to sell the business. Similarly, as a business owner, you 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.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on X @AdamMGrossman and on Threads, and check out his earlier articles.
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It turns out that some (of course not all!) permanent life insurance policies are cheaper if you intend to keep the insurance for about 14 years or so. This is not that uncommon, assuming that often insurance is bought to protect a spouse and children from the risk of prematurely losing an adult parent/partner. 14-20 years is about how long you might need that. Of course, no salesman will tell you this and no company will encourage you to keep a policy that long or, for that matter, to cash it in when you have replaced that policy with actual assets by saving 15% a year….
Regarding whole life insurance, a business does not have to be very large to benefit from a policy. My in-laws owned a small farm in Central California that supported them in a middle-class lifestyle. But land is expensive in California. My in-laws had a second to die whole life policy in an irrevocable life insurance trust. When my mother-in-law died the family could not have kept the farm if the policy had not existed to pay the estate taxes.
I think there is confusion between “risk” and “volatility”–volatility is the movements both up and down that can be severe. Of course when we look at volatility we probably attribute that to the downside, not the upside, and why not? . I have found that many investors when they mention risk are really talking volatility.
To me risk is the chance the investment will be lost.
To point 4: the trouble with risk is that everyone wants to get rich quick, so stocks with growth potential are already very richly valued. This makes risk even riskier.
Good article, as usual. I often hear that both whole life and annuities are bad. But as you note about whole life, that’s not always true.
A friend recently bought a fully paid up whole life policy. His goal is to ensure that his companion receives a modest sum. Neither LTC costs nor greedy relatives can claim that money .
Maybe. If his named beneficiary dies before him and he failed to name a contingent beneficiary who is still alive then the life insurance benefit would likely become payable to his estate and thus could become subject to any debts or the provisions of his will or his state laws if he did not have a valid will at his death.
There’s also no number that perfectly captures the risks that matter most for retirement investing: risk of permanent loss, risk of bad returns in bad times, or risk of outliving your savings. But there’s an endless list of choices an investor can make that loads our dice for such grief.