Financial Reference

I usually agree with Jonathan Clements. (He writes the “Getting Going” article for the WSJ.) I also usually agree when someone has a disagreement with conventional wisdom. But parts of the article he wrote entitled “Five Bits of Conventional Wisdom to Ignore” were flawed to the point of being misleading. (See article, subscription required.)

First, he writes that homes are not the greatest investment of all time. While I agree with that statement, I disagree with much of the rest of his argument. He argues that there is no real cash flow from a home (and gives short shrift to implied rent). Also, he argues that you need to trade down to a cheaper home to realize your gains. These are both incorrect — he ignores the opportunity cost. If you did not own your home, you would have to pay rent. Rent that would theoretically have to compensate the owner for his investment and compensate for the agency costs incurred in a non-owner occupied property. By owing, you are forgoing rental payments for mortgage payments (and taxes, etc.) Also, you do not have to scale down your investment to realize your gains. The opportunity cost of owning is renting. To find your gains, compare the outcome of owning versus renting. It makes no difference how you invest the proceeds.

Second, he criticizes people for thinking they can make money in stock market. While I agree that most people end up trading too much by chasing trends and usually pay too much for “professional” advice, his math is seriously flawed. He argues that you should expect a 6% gross return from a portfolio of bonds and stocks; of this 2% goes to fees; then 25% goes to taxes, netting a 3% annual return. My experience is much different than this. The stock market has returned an average of 11% in the past — even if we assume a lesser return we should still see 8-9% long-term. Then you would have to choose the most expensive funds on the market (the average expense ratio is 1.25%). Then you would have to have either all short-term gains or a mix of short- and long-term gains and be in the highest tax bracket to hit 25%. The real expected return should be at least 5-6% for most of us, not 3%.

He next argues that you should invest in sectors you believe to be overvalued. The reason for this is that we are overconfident in our ability to predict which sectors will perform well. For most people –people who don’t spend time in finance — this is good advice. However, for those of us who put in the effort, we can easily see that we should not invest in expensive markets. For example, I stayed out of tech during the late 90s. There were a few years I lagged the market, but in the end, I had the last laugh. Today, I am out of REIT and even though I missed some recent gains, I am optimistic I made the right choice. It’s not about hitting every market rise but being right in the long-run.

He next says that is doesn’t matter if you invest internationally or domestically, or in bonds or stocks. What matters is you don’t chase trends. For the most part, he is right. Sticking to your guns and not chasing fads is most important. However, it is important to have the right allocation for your risk needs.

Last, he makes the point that you should invest according to your risk tolerance and not your risk needs. This is wrong! A retiree should not invest in stocks if he can not afford the risk. If his portfolio decreases by 10-20% in one year, how will that affect his tolerance? The most risk tolerant person can become extremely risk averse if he is on the brink of disaster. Of course, if the retiree has the capital to afford to lose a large part of your portfolio, then it’s not an issue. But the portfolio should be structured to the risk needs of the retiree first and to the risk tolerance second.