Over the course of my career, I’ve encountered many questions from friends and clients about financial matters that to professionals in the industry would seem relatively simple. It occurred to me, however, that this actually should be expected as so often financial affairs can be counter-intuitive, or at least not so obvious as we might think. Here are just a few examples of common investment misperceptions I’ve seen again and again over the years:
Many people view stock and bond prices in absolute, not relative terms:
Question: “Isn’t it a better deal to buy the $20 stock than this pricier $100 stock?”
Answer: Of course, you can buy more shares of a $20 stock for the same amount of money invested, but that doesn’t mean it offers a better value than the $100 stock. For example, the price of the stock relative to the profits of the company should be considered. If the $100 stock trades at a price-to-earnings ratio of 10 times next year’s earnings, it could be considered cheaper than the $20 stock that trades at 15 times next year’s earnings. To paraphrase Warren Buffett, when investing in a stock, the question one should ask is not how many shares my dollars can buy, but how much value my investment offers.
Question: “If I will actually lose money on the principle of this ABC bond yielding 5% and trading at a premium, why is it a better value than this XYZ bond yielding 4.9%, and trading at a 5% discount?
Answer: All else being equal, even though one would technically ‘lose’ money by paying a premium for the XYZ bond that matures at par, the stated yield-to-maturity (or yield-to-call / yield-to-worst, if applicable) takes into account the price of the bond, and the fact that it is higher means that it should generate a higher return over the holding period than the lower-yielding ABC bond, despite the absolute price of the bond being lower.
When considering making an investment, people often have the holding period for stocks and bonds backwards:
It remains amazing to me that many people do not hesitate to make a 30-year commitment to buy a real asset such as a house with borrowed money, but the idea of owning stock in a 100-year old company for more than a few weeks at a time remains alien to them. Perhaps it is because our media culture has convinced many that stocks should be treated not as shares of companies to be owned but as gambling chips to be traded, all too many people think of them as short-term investments. For example, whenever I’ve recommended a bond to a client, I’ve been met with skepticism if the stated maturity of the bond was generally greater than about five years. For whatever reason, whenever I discuss bonds, there seems to be a visceral reaction to seeing a stated “expiration date” on an investment. I can say with confidence, however, that whenever I’ve recommended a stock or equity ETF, not a single investor has asked how long he or she should consider owning it.
The reality is that many people have this backwards. The fact that bonds have a stated maturity date, even if it is ten years in the future, makes them, in a way, shorter-term investments than stocks. Because they have no expiration date, stocks should be considered perpetuities, which is why Warren Buffett has stated that his “favorite holding period is forever.” Obviously there will be various interruptions in life that will upset long-term investment decisions, but investors would be better served if they, instead of asking themselves “When should I sell this stock?,” ask rather, “How long am I committed to owning this company?”
Debt reduction is a noble, but not always practical, ideal
One of the most common questions I’ve been asked by those preparing for retirement is whether or not they should take distributions from their retirement accounts, pay the taxes, and payoff their mortgage. Their logic, of course, is that while their nestegg will take a hit initially, they will require less from their portfolios over their retirement. However, as always in financial matters, one’s decisions should be dictated considering all the variables in play, and with a consideration not just of the advantages, but also of the disadvantages of a given course of action.
In fact, individuals should train themselves to think more like corporations. Corporate executives are constantly analyzing the best ways to employ the capital at their disposal as they try to accomplish their goals and plan for contingencies. If tax rates are high, and interest rates low, a corporation might issue debt, the proceeds of which they can employ for strategic purposes, or to ensure smooth operations during economic downturns. Similarly, an individual should consider that when exchanging a liquid asset (his retirement funds) for a fixed asset, he is no richer on a net basis. While he wouldn’t have the mortgage interest to pay in the future, he is imposing limitations on his future financial flexibility that such a decrease in liquid capital could constitute. The simplest way to think of this is that your mortgage expense is fixed, but your investment returns are variable. You are essentially cannibalizing a good chunk of your future returns and limiting your financial flexibility because of a desire to be debt-free at all costs.
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