- Buying bonds directly, rather than via a bond mutual fund, protects me from any decline in value caused by rising interest rates. This is a myth because if I roll over my bonds into new ones as they mature, I really am running a mini version of a bond fund. With both a bond fund and individual bonds I can avoid realizing a loss by never selling. And with either I will realize a loss if I sell when rates have risen above where they were when I made the investment.
- Inflation is low now, so it cannot hurt me in the future. Duh. We cannot forecast the inflation rate ahead more than a few years. The current low inflation rate is fueling complacency among fixed income investors. But, if annual inflation ever goes back to double digit rates - where it was for a few years in the 1980s - the income and principal from our long term bonds and annuities will buy way less than we expect. Just think of the rise in the price of an ice cream cone or movie ticket over the years and project that ahead over a thirty year retirement.
- My stock market losses equal what I am down from my peak, not from my cost. If I invest $500,000 and it climbs to $4 million over a couple of decades, and then a bear market chops it down to $2 million, I go into shock because I think only that I have lost half my money since the peak. So I liquidate my portfolio and never buy stocks again. I regret that I didn't keep it all in a safer investment, but never calculate how little it would be worth today if I had done that.
- I fear risk. I do not realize that what I really fear is volatility. I'll be happy with a low return from a portfolio of stocks and bonds if it has only modest fluctuations in value. I care more about the steadiness of my return than the size of the return. I think that I am reducing risk, but what I really am reducing is volatility and I am willing to accept a low rate of return if that is the cost of having low volatility.
- Stock dividends are like a free lunch. I fail to view them as reducing a stock's price, even though paying the dividend leaves the company either with more debt upon which they must pay interest or less cash to reinvest in their business (or to take over other companies, which could add to profits).
- Annuities issued by insurance companies are guaranteed. They are, but the guarantor is an insurance company, which can leave investors high and dry if it becomes insolvent. AIG was AAA rated not long before the Fed bailed it out in 2008. Ben Bernanke testified before Congress that one reason the Fed acted was that the failure of AIG would have been such a massive event that it would have bankrupted virtually all of the state insurance pools, which are funded by insurers in each state to bail out policy holders, within limits, in case an insurer goes bust. Thanks, Ben.
- Stock splits mean something. They don't. They tend to occur after a stock's price has risen, but they tell you nothing about the future. Each stock split knocks down the share price proportionately, so on the day of a 2-for-1 split you would have twice the number of shares but the price of each share would have been cut in half, instantly.
- I know that diversification is a good idea, but some investors think that a portfolio of three very solid stocks can provide sufficient diversification. It can't. Returns from such a narrow portfolio are likely to vary greatly from year to year, either good or bad, compared to the S&P 500. Other small investors feel sufficiently diversified if they spread their portfolio over several blue-chip drug companies. They are wrong; they must diversify across industries.
- Adding foreign stocks to my holdings will lower the volatility of my stock portfolio. An excellent Vanguard study (pdf) does advocate having a substantial allocation to non-US equities in order to reduce overall stock portfolio volatility. However, Figures 3 and 7 in that report show that from 1970-2010, the volatility of a stock portfolio that included substantial non-US equities would have been reduced only by about 1/15 of what an all-US stock portfolio would have experienced. And the study points out that world stock markets have become even more synchronous with one another in recent years, so that the benefit of international diversification has been shrinking. I recall that during the financial panic of 2008-2009, a time when investors would have loved to have held some investments that marched to a different drummer, worldwide stock markets were highly correlated with each other as all spiraled downward, leaving a trail of pain and agony among investors. A further point is that stock markets in smaller, fast-growing economies may be heavily concentrated in their lightly regulated banking industry and highly cyclical natural resource industries. A safer way to invest in worldwide growth while diversifying geographically is to invest in those US multinationals which derive much of their sales and profits overseas. Think: IBM (NYSE:IBM), Apple (NASDAQ:AAPL), Dow Chemical (NYSE:DOW), Coach (NYSE:COH), Oceaneering (NYSE:OII), Goldman Sachs (NYSE:GS), Coca Cola (NYSE:KO), Johnson and Johnson (NYSE:JNJ), Boeing (NYSE:BA) and McDonald's (NYSE:MCD).
Disclosure: I am long IBM, AAPL, DOW, COH, OII, GS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.