Investment Fallacies
There are widely-held investment notions that are in fact simplistic, and can cost investors dearly. Some of these have even been promoted in the media as sound practices.
1. Attempting to avoid the payment of capital gains taxes.
Not many people enjoy paying taxes, but sometimes tax-avoidance can entail greater risk and reduce overall returns. These investors lose sight of their objective - to maximize their risk-adjusted returns after taxes - and instead become fixated on avoiding taxes altogether, especially those levied on realized capital gains. An investor may be hung up on the fact that he will incur a 15 percent federal levy on the realized gain, while ignoring an uncertain but potentially enormous cost should the stock collapse.
2. An investor may decide to "wait for the stock to come back."
Investors all too often fret about the price they have paid for a security, and allow that concern to influence their immediate investment decisions. Investors often lament the fact that the value of a particular security had fallen from what they had originally paid for it, and that they would not sell it until it "came back" to that level.
This rationale is flawed. The cost of any asset is a sunk cost; it is irretrievable and therefore should not affect an investor's decision. The holder of any asset has two basic choices at any given time: he can continue to hold the asset, or he can sell it and invest the proceeds in some other asset. Each asset has some future value which is unknown, but the better outcome has nothing to do with what the investor paid for his security once upon a time.
3. The idea that one should never spend out of capital.
Some investors, especially those approaching retirement, are wed to the notion that they should live off of their investment income (dividends and interest) and avoid "dipping into capital" by selling securities in order to meet their spending needs. While this was at one time a reasonable maxim, it is now no longer a valid concept in financial planning.
At one time the U.S. dollar was defined as and redeemable on demand, in specific amounts of gold. High-grade bonds and similar instruments thus were even better than gold because they paid interest. The long-term stability of prices seemed assured, so bondholders were equally well-assured that the long-term value of their bonds would not deteriorate. Spending from capital was considered imprudent; only the interest income from such holdings should be used to meet living expenses.
But since that time the gold standard has been abandoned, and monetary inflating has become institutionalized. It is now a virtual certainty that when bondholders redeem their bonds seversl years hence, the purchasing power of their proceeds will have diminished since the time at which they purchased the bond. And the real value of the bond's interest payments will have eroded as well.
In this environment, investors are forced to consider supplementing their fixed-income holdings with common stocks and gold, which have historically outpaced price inflation. These provide returns largely through capital appreciation; they are purchased so that at some point they may be sold. Thus spending out of capital is no longer to be avoided, and is in fact an inherent part of a wise investment strategy.
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1. Attempting to avoid the payment of capital gains taxes.
Not many people enjoy paying taxes, but sometimes tax-avoidance can entail greater risk and reduce overall returns. These investors lose sight of their objective - to maximize their risk-adjusted returns after taxes - and instead become fixated on avoiding taxes altogether, especially those levied on realized capital gains. An investor may be hung up on the fact that he will incur a 15 percent federal levy on the realized gain, while ignoring an uncertain but potentially enormous cost should the stock collapse.
2. An investor may decide to "wait for the stock to come back."
Investors all too often fret about the price they have paid for a security, and allow that concern to influence their immediate investment decisions. Investors often lament the fact that the value of a particular security had fallen from what they had originally paid for it, and that they would not sell it until it "came back" to that level.
This rationale is flawed. The cost of any asset is a sunk cost; it is irretrievable and therefore should not affect an investor's decision. The holder of any asset has two basic choices at any given time: he can continue to hold the asset, or he can sell it and invest the proceeds in some other asset. Each asset has some future value which is unknown, but the better outcome has nothing to do with what the investor paid for his security once upon a time.
3. The idea that one should never spend out of capital.
Some investors, especially those approaching retirement, are wed to the notion that they should live off of their investment income (dividends and interest) and avoid "dipping into capital" by selling securities in order to meet their spending needs. While this was at one time a reasonable maxim, it is now no longer a valid concept in financial planning.
At one time the U.S. dollar was defined as and redeemable on demand, in specific amounts of gold. High-grade bonds and similar instruments thus were even better than gold because they paid interest. The long-term stability of prices seemed assured, so bondholders were equally well-assured that the long-term value of their bonds would not deteriorate. Spending from capital was considered imprudent; only the interest income from such holdings should be used to meet living expenses.
But since that time the gold standard has been abandoned, and monetary inflating has become institutionalized. It is now a virtual certainty that when bondholders redeem their bonds seversl years hence, the purchasing power of their proceeds will have diminished since the time at which they purchased the bond. And the real value of the bond's interest payments will have eroded as well.
In this environment, investors are forced to consider supplementing their fixed-income holdings with common stocks and gold, which have historically outpaced price inflation. These provide returns largely through capital appreciation; they are purchased so that at some point they may be sold. Thus spending out of capital is no longer to be avoided, and is in fact an inherent part of a wise investment strategy.
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posted by Bob Moser at
8:27 PM
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