After two decades in financial planning, I’ve witnessed many people misled by certain investment strategies. Here are three common ones to watch out for.
“We have outperformed the S&P 500 over the past 10 years.”
The S&P 500 offers a solid gauge of the U.S. stock market, but it’s not the only one—indexes like the Dow Jones U.S. Composite and the Morningstar US Market Index can provide better insights. However, a common tactic I notice is that some compare the total returns from financial professionals with just the price returns of the index.
S&P 500 stocks typically provide dividends, yet index returns often ignore these (unless stated otherwise) and focus solely on price. As of March, the S&P 500’s 10-year cumulative return stood at 257.2%, or an average of 13.7% per year. But, once dividends are reinvested, that total return skyrockets to 321.7%, equating to about 15.6% annually.
Professionals who stress performance comparison without factoring in dividends can lead to misleading assessments.
This is especially pertinent for certain financial products like Buffered ETFs, which aim to reflect S&P 500 returns but often disregard dividends. Many fixed index annuities operate similarly, excluding the critical aspect of dividends from total return calculations. To ensure accuracy, make sure any benchmark you consider reflects the index’s total return; otherwise, it’s an incomplete picture.
“Why not buy a municipal bond fund when our bond buyers can earn much more for the same credit quality and term?”
Here’s an example: “While the iShares National Muni Bond ETF MUB offers a yield of just 3.25%, our bond buyers could assemble a similar portfolio yielding 4%. That’s an increase of 0.75%.” But, these yield comparisons aren’t truly equivalent. ETFs and mutual funds are securities governed by the SEC, while directly purchased municipal bonds come under different regulations.
The Local Securities Rulemaking Committee permits certain income types to count toward yield. Municipal bonds generally get issued at a premium and may be called at par value. For instance, consider a 5-year policy bought at a 5% premium; this would yield around 1 percentage point of premium as income each year. However, the advertised 4% yield by bond managers typically neglects fees, meaning actual income can be considerably lower.
Take simple annuities as another example. A 65-year-old man investing $100,000 might receive an 8% “lifetime income,” far exceeding the 30-year Treasury bond yield of 4.8%. The catch? If the insured passes away, there’s nothing left for heirs, whereas the Treasury bond remains valuable at maturity.
“Don’t pay off your mortgage because we can make more money for you.”
The argument often goes like this: Your mortgage interest rate is 5%, but with tax deductions, it’s effectively around 3%. They’ll suggest you can earn 7% with a balanced portfolio, so paying off the mortgage is silly.
But here’s the thing—clearing your mortgage doesn’t impact the home’s market value, giving you a guaranteed profit. Stocks and bonds carry inherent risks. If we take this line of thinking too far, it would mean everyone should just take loans to invest, which is, quite frankly, a risky strategy.
Moreover, while the tax benefit adjusts the mortgage rate down to 3%, it’s crucial to remember that investment income will still incur taxes. In my experience, clients often find themselves paying taxes on their portfolio income, yet receive minimal benefits from their mortgage interest deductions.
Final Thoughts
When I explain these tactics to clients, they sometimes view the individuals using these strategies as unscrupulous. However, I don’t necessarily think that’s fair. Many respected professionals in finance employ these tactics while actively contributing to charitable causes.
So, what drives them to use these methods? I suspect it’s often a lack of understanding. Few advisors grasp that the interest from municipal bonds includes returning clients’ money. And as Upton Sinclair pointed out, “It’s hard to make people understand something when their not understanding it affects their pay.”
To protect yourself, always base your benchmarks on the total return of the appropriate index. Additionally, recognize that returns of principal shouldn’t be counted as income, and remember it’s generally unwise to borrow money (through mortgages) to lend it at a lower rate (like bonds).
