Top 5 Myths

Summary: Wall Street brokers continue to perpetuate the myth of “buy and hope” and they continually preach that the market will always rise over time.  In truth, drastic drops in the market are inevitable and the average investor can’t afford to lose. Principal protection should be the number one component of any investment strategy.  

The Facts: Crestmont Research, a hedge fund data research firm founded by prolific author Ed Easterling, completed a fascinating study on the true impact of a “buy and hold” approach. “Whereas the 'relative return' investor (tracking stock market indexes) will generally experience 100% of the downside and 100% of the upside to achieve market returns, the 'absolute return' investor only needs a fraction of the upside when downside losses are limited.” Specifically, over the course of 50 years, if one could avoid all down years, one would only need to participate in 25% of the gains to match the “buy and hold” approach.

The point is, if you can always preserve principal and avoid taking part in market losses, you don’t need to take the risk that most buy/hold investors must take.

The Real World: From 2000 to 2003 the market went down 38%. But from 2004 to 2007 the market rocketed up 83%.   Financial planners highlight this performance to lead you to believe that you would have missed out on these massive gains had you not “bought and held.” Lets look at this in more detail (see chart below).  If you had invested $100,000 on day one of 2000, by the end of the 2003 your account balance would be $62,000 (or down 38%).   Then by the end of 2007, your account has grown by 83% so your new account balance is a whopping $113,460. So when all is said and done, your average return over the course of the 7 years period was 1.92% annually.

Perpetuated by Financial Entertainers and Mutual Fund Managers

Summary: Repeated investment performance studies have shown that only a small percentage of individual investors can beat or even match the long term stock market returns. There are two main reasons for this. The primary culprit is that most try to time the market. They add to their holdings during boom times and pull out when the market drops. Not only does this “Buy High & Sell Low” activity cause them to miss out on market rebounds, which it has always done following a major drop, but it also further reduces returns by using active managers, that charge significant fees and underperform the market.   A Dalbar study over a 20 period ending in 2010 showed the S&P 500 averaged a 9.1% return (including dividends) while the average US stock investor achieved only a 3.8% return.  

Consider the following headlines:

"The Dow Plunged 634-76 points the first trading day after the U.S. downgrade for the biggest drop in two years. Over the next three days it rebounded 429.92 points, plunged 519.83 points and rallied 423.37 points." - December 15, 2011

"Only 4% of U.S. Stock  Funds have beaten the actual performance of the S&P 500 over the last 10 years?" - December 18,2011

"Hedge Funds Facing Worst Year Since 1990. Many investors are running to the sidelines." - December 9, 2011

"The average diversified U.S. stock mutual fund has fallen 5.9% this year, vs. a 1.4% loss for the Standard & Poor's 500-stock index, says Lipper, which tracks the funds. Out of 8,036 funds, 7,399, or 92% are showing a loss." - December 18, 2011

Summary:  When mutual fund manager’s state their fee, they are often stating their management fee and not the total fees. In a March 2010, Wall Street Journal article titled “The Hidden Costs of Mutual Funds,” the author wrote that the average fund manager charges 1.3% per year as a management fee (according to Morningstar). However he goes on to address that this stated management fee is just one of many fees that are being charged, rarely disclosed and expertly concealed:

“There are other costs, not reported in the expense ratio, related to the buying and selling of securities in the portfolio, and those expenses can make a fund two or three times as costly as advertised.”

This means that when all fees, hidden and disclosed, are added together, its more likely that fees average closer to 3% per year.   To be clear, this on the total value of your account! If you invested $100,000 and the market didn’t advance over 10 years (ie. 2000 to 2010), the fund still earned 3% each year or approximately $30,000 in fees over the 10-year period. This leaves you with a balance of $70,000. The vast majority of Americans invest in mutual funds via their 401k plans. So in addition to the mutual funds fees, there are additional fees that plan sponsors charge. Below is a list of some but not all of their fees:

However, many of the above fees are not listed in the prospectus or annual report. They are listed in the statement of additional information, a special document one must request from the fund provider.  The above chart shows the impact of fees on growth. Assuming an 8% annual return, you can see that an account with $1,000,000 at the beginning will be drastically impacted over a 30-year period. The difference between 1% and 3% percent is over $3 million dollars in fees!

Summary: In traditional financial planning, once one has maxed out their 401k plan (or other qualified plan), they invest the balance in a fully taxable accounts.

The Numbers: The following shows a dollar doubling every year for 20 years without tax, a common hypothetical scenario to illustrate the power of compound growth.  Now, lets take the same example, however in this scenario, Uncle Sam is going to tax the gains each year at 33%:  

The Real World: With astronomical deficits and government spending, rising taxes on both income and investment earnings are seemingly inevitable. Truth is, we are currently experiencing a relatively low historical tax environment. According to USA today, “Americans are paying the smallest share of their income for taxes since 1958, a reflection of tax cuts and a weak economy.” One only needs to look to our country’s past to discover that income tax rates have consistently averaged much higher. Therefore, by deferring taxes into the future, you could very well be at a higher rate which will dramatically effect your net spendable income at retirement.

Summary: In their marketing materials and annual reports, Mutual Funds are legally allowed to display their returns as average returns (not the real or compound rate of return). This is incredibly misleading and yet this seems to be the metric of choice when selecting the “best” managers.

The Numbers: When we look at the example, we will see that the average return, the way Wall Street would calculate it, is much different than the real or compound rate. Adding or subtracting the annual returns and dividing by the number of years calculate an average rate. Although this sounds reasonable, lets look at a 4-year period in which the average return is 0% while the real return is drastically worse (down 43.75%). So while managers may boast of their average returns, you will always want to know the true compound/real rate of return because what matters to you is how much you can spend when you need it the most.