Common Portfolio Misconceptions

19986413_sLately, I have met a slew of folks all wanting to have the same old discussions about allocation strategies, historical performance, top mutual fund managers, price to earnings (PE) ratios, or whatever else their brokers deem to be the hot topic of the day in the shark-infested shallows of the stock market noise. And although I am always happy to discuss market-related issues, I would rather talk to these people about some misconceptions and problems their brokers don’t discuss with them.
 
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I really do get frustrated when I hear all the misinformation that is hurled at them. So, let me share with you, Cutter Family Finance readers, the same information that I share with them so you can make informed decisions about your financial future.
 
Let’s talk about the misperception that an investor will eventually “get back to even”—a mentality people cling to today because of past severe market sell-offs. Please understand that if four, five or even six years have passed since such a downturn, and inflation is 2 1/2 to 3 percent, then an investor is not “back to even” even if their account value equals what it was before the downturn. For example, if an investor had $500,000 five years ago and he is now back up to $500,000, he is not “even” with where he started because his money would need to have grown to about $565,000 to keep up with a 2 1/2 percent inflation rate. In addition, he has lost the opportunity to gain for those years. If he had gained 4 to 5 percent over those five years, his money would have grown to about $625,000.
 
Another problem is that currently people have a false sense of security. I call it the “warm fuzzy feeling.” Because the market has improved these past few years, many investors are getting that warm fuzzy feeling that everything is okay again and may even get better if the market goes higher. They have been through the “panic” stage when the market bottomed, then rode through the “frustrated” stage when the market was treading water for awhile and now are starting to feel better as their account balances improve.
 
Folks, this is what we know. Since 1900 we have had a market correction every five to six years and we are six years in to a “recovery.” Here is another thing we know—80 percent of market corrections happen between June and October. Think about that for a second; aren’t we in the making for a perfect storm? When I ask people what their strategy is to get out of the markets, well, they don’t have one.
 
Shouldn’t we be talking about how to avoid another significant market correction? Heck, even John Bogle, president of Vanguard, recently said to expect three more “significant” market corrections of 50 percent or more before the end of the decade. Or, how about having a discussion about how mutual fund managers are forced by their fund bylaws to stay invested even when the market tanks. Now that would be nice!
 
Another misperception that many people have is that all investments are created equally for purposes of taxes. I often discover that folks have non-deductible losses in their qualified (retirement) plans. Why? This is tax inefficiency at its best. Alternatively, they have phantom income from capital gains distributions in mutual funds held in non-qualified accounts.
 
Phantom income taxation occurs when an investor is taxed on capital gains even when the portfolio has decreased in value. Most investors are not taught strategies to either avoid or at least lessen the impact of both phantom income in non-qualified accounts and non-deductible losses in qualified plans.
 
Lastly, many investors think they have a higher rate of return than their true rate of return. They may think they are getting 8 to 9 percent per year, but they have not actually done the math and truly quantified the numbers. In fact, those same investors may only be getting 2 to 3 percent because they haven’t accounted for certain fees, costs, taxes, and other expenses they are unfamiliar with. These same investors are making decisions about their risk tolerance without knowing their actual rates of return.
 
So, I typically ask two questions that quickly help folks establish their true risk comfort level. First, I ask how their lifestyle would change if they had a 30 to 50 percent gain in their investment portfolio. Some folks respond that they might spend or travel a little more, or just feel more secure. In fact, they usually suggest that nothing will dramatically change. Second, I ask how their lifestyle would change if they had a 30 to 50 percent loss in their investment portfolio. Most respond that they would be devastated, would need to move to a smaller home or make some other dramatic change. The fact is this, losses have a more significant impact on an investor’s lifestyle than does a similar gain.
 
It is time to ask the right questions. It is time to have the important discussions.
 
Be vigilant and stay alert, because you deserve more.