Myths On Money

The Word on the Street

There is a prevailing notion in our society that it is possible to get extraordinary returns out of the stock market by following a particular investment strategy, buying certain sectors of the market, finding stocks with certain characteristics, or in hiring a sharp-dressed, smooth talking account manager.

The Truth

While I do not deny that it certainly should be possible to “beat the market”, the simple fact is that, based on historical stock market and mutual fund data, very few account managers or mutual funds have managed to beat the market for more than a few years at a time.

In this post…

It’s in the Pudding

One of my current favorite finance books is called A Random Walk Down Wall Street, by Dr. Burton G. Malkiel. Dr. Malkiel updates this amazing book every few years with the latest information available in the financial world, and the book is currently in it’s 36th year of publication! The reason that I mention this book here is because one of Dr. Malkiel’s major points is that very few, if any, active investors and fund managers actually beat the market for more than a few consecutive years.

Mutual fund companies have strong motivations to make their funds look really good, so they have a tendency to use a little creativity when it comes to the statistics they report in regards to their funds. A prime tweaking technique involves elimination of underperforming funds from their portfolio of offerings. By closing a “loser” fund, the poor returns it was providing are removed from the pool of statistics used to measure the average return of the funds the company offers.

If you want a prime example of a particular strategy working for a short period of time, then failing, look no further than the dot com boom. For a number of years, the investing mantra was “invest in dot coms, and you can’t go wrong!” Well, history has proven that that strategy was not a long-term success, and most of the fortunes created by that strategy were also lost by that strategy.

Critics of Dr. Malkiel’s premise often will cite the success of a few private investors as proof that high returns can be earned. They cite the success of Peter Lynch (who had excellent returns on his Magellan Fund for a number of years), and Warren Buffett, whose very name is synonymous with investing prowess. But, the reality is, that though there may be a few who can in fact beat the market, they are vastly offset by the numbers of those who not only can’t, but haven’t matched the market. How many successful investors have you ever heard of? One? Two? A dozen? A hundred? A hundred sounds like a lot, but at this very moment there are more than 9000 mutual funds currently available, and many thousands more that have already been closed. The media focuses on the very exceptional few, and tends to ignore the immense mass of investors who have not managed to outperform the market.

Buffett and I

Many of you who frequent the blog know my preferred investment strategy. I am a believer in efficient markets, which basically means that I, like Dr. Malkiel, don’t think you can expect to beat the market. So, if you can’t beat ‘em, join ‘em, right? I think the best approach is to simply purchase an exchange traded fund (commonly referred to as an ETF), or a mutual fund that tracks one of the major indices of the economy. Examples of such indices include the S&P 500, NASDAQ, Dow Jones Industrial Average, Russell 2000, etc. These funds have very low expenses because they are not actively managed, and do not trade stocks around very often. As a result, you manage to efficiently invest your money in the entire market. One great benefit of index investing is that you automatically get access to a phenomenal degree of diversification, which lowers the total risk of your investment.

In a recent interview with PBS’s Nightly Business Report, investing legend Warren Buffett had the following to say in regards to the complexity of the investment world:

You should always stick to what you know. I say the “know-nothing investor” and there’s nothing wrong with being a “know-nothing investor.” I spend 60 hours a week, thinking about investments and most people have got jobs and other things to do. They can buy index funds. And they’re not going to do better then an index fund if they go around and trust some guy who’s promising them very high returns. If you buy a cross section of American business and you don’t buy it during a period when everybody is all enthused about stock, you’re going to do fine over 10 or 20 years. If you buy something with the idea that you’re going to do fine over 10 months, you may or may not. I do not know what stock is going be up 10 months from now, and I never will.
Warren Buffett

If you want to try to play roulette with your money, then go ahead and try to find the >1% of fund managers who will beat the market for more than a few years. For me, I am going to stick with the market, and almost guarantee that I will outperform 99% of all money managers.

In this post…

The Word on the Street:

Whenever someone wishes to make a large purchase on credit (like a house or a car), the lender will often try to sell them an insurance policy. These policies are supposed to protect your family from having to repay the loan in case the buyer dies.

The Truth:

This insurance does not truly protect you or your family. Why do you think they press the issue so hard? Is the car salesman or the dealership really out there to do you favors? No. They are out there to make a profit. And there’s nothing wrong with that. But, as a consumer, you ought to be aware that credit insurance really only benefits the lender. When you buy credit insurance, you are in fact guarantying your lender that it’s loan will be repaid. You are paying their insurance premium!

What is Credit Insurance?

The insurance that the salesman/banker will try to sell you is a type of insurance called credit insurance, although they may not call it that. What credit insurance does is pay off the remaining balance of your loan if you should die. If the loan is sufficiently large (like in a mortgage) and you meet certain criteria, a lender may require you to purchase this insurance before they will issue the loan. This is a typical arrangement for mortgages where the buyer has only a small down payment. When it comes to auto loans, these policies are usually discretionary, and will often be paid for with one large premium payment at the time of purchase. This post focuses on discretionary insurance for auto loans, rather than potentially mandatory insurance for mortgages.

How they sell it

When making a large purchase, people have a tendency to downplay the magnitude of some costs. They figure, “I’m already paying $20,000, what’s another $400 more?” By exploiting this tendency, car salesmen are often able to convince the buyer that the cost of the insurance is a small price to pay. They bury the cost within the larger cost of the car and make it seem as though it is a good deal.

This next tactic is downright cruel. What the salesman will tell you is that this insurance will protect your family from having to pay off the loan should you die. He tries to convince you that your family will be left financially bereft by having to continue to make the car payment. By playing on the emotional bonds within your family, he impairs your rational judgment within a cloud of powerful emotions. This is how they convince you that this insurance is a good deal, and will benefit your family.

Don’t fall for it

It’s true that your family will receive the money to pay off the loan, and that will benefit them. It’s also true that you ought to use life insurance to help pay off your debts so your family can be free of them should you die. So why shouldn’t you get the credit insurance?

Short answer:

It’s way over priced!

Long Answer:

An example. Suppose Herb buys a $20,000 car, taking out a $15,000 loan for 4 years. The dealer offers credit insurance to cover the loan in case he dies. The policy is available for an up-front cost of $500, which they offer to include with his loan. Is this insurance a good deal? Assuming Herb is 35 years old and in good health, for $125 per year over a 4-year period, Herb could purchase a traditional level term life policy for at least $100,000 coverage. So, for $500, he could have $15,000 of declining life insurance (to cover the car loan) for 4 years, or for $500 ($125/year for 4 years) he could have $100,000 of coverage that he could keep that his family could use any way they wish, should he die. Dollar for dollar, the credit life insurance is much more expensive. If you are considering buying a car and wish to cover the loan in case you die, you would be much better off purchasing traditional, term life insurance than you would to buy the credit insurance the dealer may offer you.