Don’t Be Fooled By These 3 Investing Tricks
Over more than two decades as a financial planner, I’ve seen many people fall for some misleading investing tactics. Here are three very common tricks of the trade that you should guard against.
“Our firm has bested the S&P 500 over the last decade.”
The S&P 500 is a very good measure of the US stock market, although I believe total market indexes like the Dow Jones US Total Stock Market Index and the Morningstar US Market Index are better. But here’s the trick I often see: comparing a financial professional’s total returns to an index’s price returns.
The stocks in the S&P 500 typically pay dividends, but the index’s stated return doesn’t account for those dividends (unless it says otherwise)—they’re based on the price of the index. As of March, the cumulative 10-year return of the S&P 500 is 257.2% or 13.7% annually. But with dividends reinvested, the index’s total return jumps to 321.7%, or 15.6% annually.
A financial professional who is highlighting their total performance, which accounts for dividends, against an index return is making a misleading comparison.
This is especially relevant to some buffered ETFs, such as a derivative product that is designed to give the S&P 500’s return within certain constraints. It uses the pure index, which strips out dividends. Most fixed-indexed annuities work the same way: They strip out the dividends of the equity-indexed annuity. The point is that the pure index is only part of the total return of that index.
To avoid this trick, make sure the benchmarking index you are looking at is the total return of that index. In other words, if you are looking at your total return, compare it with the total return of the appropriate index.
“Don’t buy a municipal-bond fund when our bond buyers can get you so much more in income with the same credit quality and duration.”
An example of this trick goes like this: “The iShares National Muni Bond ETF MUB yields only 3.25%, while our bond buyers can build a similar portfolio yielding 4% with similar characteristics. That’s an extra 0.75% in yield.”
The yield quotes compared above are apples to oranges. Exchange-traded funds and mutual funds are securities and are regulated by the SEC. I quoted the 30-day SEC yield. The muni bonds bought directly are regulated by the Municipal Securities Rulemaking Board, a self-regulatory organization, which allows return of principal to be included in income and yield. Munis are typically issued at a premium and mature, or are called at par. So, for example, a five-year muni purchased at a 5% premium will have roughly 1 percentage point amortization of premium each year included as income. Naturally, the 4% yield claimed by the bond manager didn’t include their fees, so they typically yield far less economic income than the bond fund.
Other examples of income-that-isn’t can be seen in some simple annuities. For example, a 65-year-old man with $100,000 can get 8% “income for life.” That’s a lot better than a 30-year Treasury bond yielding only 4.8%. Of course, the annuity includes the return of principal since the heirs or spouse get nothing when the insured passes away, while the Treasury is still worth $100,000 when it matures.
“Don’t pay off your mortgage, as we can earn far more for you.”
The argument goes like this: Your mortgage rate is 5%, and you get a tax deduction, so it’s only costing you a bit over 3% after taxes. We can earn 7% on your balanced portfolio. Don’t even think of paying it off.
First, understand that paying off the mortgage is a risk-free return because it has no impact on the price for which the home will ultimately be sold. Stocks, and even bonds, are risky. By extrapolating the logic of comparing a risk-free use of money to a risky one, we should all take out a margin loan to put more in stocks. That’s absurdly dangerous, of course.
The second part of the trick is that the mortgage rate of 5% was adjusted downward to 3% owing to tax savings, while the portfolio return wasn’t. You will obviously pay taxes on investment income. I typically see clients getting little or no tax benefit from the mortgage, while they are paying income taxes and the 3.8% investment income tax on the earnings from the portfolio.
Wise Words
When I explain these tricks to clients, they have a tendency to consider those who played them to be bad people. I actually don’t think that’s true. Some of the nicest people in the financial-services industry use these tactics. They donate money and time to worthy charitable causes.
So why do they use these tricks? In my opinion, they simply don’t understand the logic above. I’ve seen very few advisors who understood that muni-bond interest income included the return of the client’s own money. Many advisors will actually get upset with me when I explain that a mortgage is the inverse of a bond. As Upton Sinclair said, “It is difficult to get a man to understand something, when his salary depends on his not understanding it.”
My advice is to always make sure any benchmarking is to the total return of an appropriate index. Make sure the return of your own principal isn’t being counted as income. Understand that it generally isn’t profitable to lend money out (bond) at a lower rate than you borrow it (mortgage).
