The world of personal finance has changed beyond all recognition in the past 30 years and much progress has been made. But a lot of today’s financial advice and planning is based on unfounded or downright wrong assumptions and beliefs – or, as I term them, ‘money myths’.
I’ve identified 12 money myths. Here are the first three.
Myth 1 – Investment risk is the amount your portfolio fluctuates in value each day
The most important risk is failing to meet your financial life planning goals, which means not running out of money when you need it.
If you are fully diversified, more risk means the potential for a wider range of possible return outcomes. The return on equities varies a lot from year to year, but their long-term average returns don’t vary as much when measured over a typical investor’s holding period – that is, more than 30 years.
Based on history and theory, over 10 or 20 years a bond fund or ETF will often have a lower probability of losses than a world equity fund or ETF. But the evidence suggests that, over a 30-year-plus time horizon, a world equities index fund or ETF has a lower probability of losses and a better chance of real-terms gains than cash or bonds.
The key thing to focus on is the range of long-term return outcomes, rather than expect or plan for pinpoint accuracy of returns.
Myth 2 – 94 per cent of investment performance is due to asset allocation and you need to calibrate this precisely
The seminal 1986 study on this subject by Branson, Hood and Beebower made the point that asset allocation is the main determinant of the variation of returns. In other words, just knowing a portfolio’s mix of cash, bonds and equities could help you guess 94 per cent of the time how variable returns would be, not what that return would be.
The father of modern portfolio theory, Harry Markowitz, considered the optimal asset allocation for his own money but found it a challenge.
“I visualised my grief if the stockmarket went way up and I wasn’t in it – or if it went way down and I was completely in it. So I split my contributions 50-50 between stocks and bonds,” he said.
A perfectly calibrated asset allocation derived from spurious financial modelling, based on the efficient frontier, is a fool’s errand. The most efficient long-term portfolio is an ultra-low-cost world equity index fund or ETF.
The only question is how much of a safety net – in the form of index-linked bonds – the investor wants or can afford. This should be based on their amount of capital and any ongoing savings, compared to their long-term financial goals.
Myth 3 – A client’s investment portfolio should meet or beat a relevant investment index or benchmark
The only benchmark that matters is meeting one’s personal financial life goals and to do that you need a personal plan that gives proper context to saving, investing and spending decisions.
As behavioural finance expert Dr Daniel Crosby puts it in The Laws of Wealth: Psychology and the Secrets to Investing Success: “Measuring performance against personal needs rather than an index has been shown to keep us invested during periods of market volatility, enhance savings behaviour and help us maintain a long-term focus.”
Jason Butler is an expert in financial wellbeing
Follow him on Twitter @jbthewealthman