4 Misunderstood Concepts In Personal Finance
#4 "Stocks Always Bounce Back"
The problem with getting financial tips on social media is that everyone repeats the same talking points about money and finance.
If someone gets a lot of Retweets talking about “passive income,” other content creators will copy that Tweet and send it out into the world as an original thought. They think—“this idea has a lot of engagement”— when they should be thinking, “does this idea make any sense?”
When the primary incentive is “engagement,” you are going to get a lot of people with big followings repeating ideas that are incomplete, lack context or are just wrong.
Here are four of the least understood but most popular personal finance discussion topics—I’ll do my best to sprinkle some evidence and logic on top of each of these ideas.
#1—Dollar-Cost Averaging
I tackle the issue of dollar-cost averaging in chapter 29 of my book “The Rational Investor.”
Dollar-cost averaging is an investing strategy where you decide to take a lump sum of money and slowly invest it over a period of weeks or months.
For example, if you had $12,000, you could invest right now, but you decided to invest $1,000 per month over the next year; that’s dollar-cost averaging.
Many online influencers tell their followers that investing every two weeks on payday is how you dollar-cost average into the stock market.
This is wrong.
Investing every payday looks like dollar-cost averaging but it’s lump-sum investing.
If you are investing all of your investable money the day it hits your bank account, that’s not dollar-cost averaging.
The difference might seem trivial but true dollar-cost averaging is a useful signal to investors. If you are so nervous about investing your money that you feel the need to break it up into smaller amounts and slowly invest it over several months, that is telling you that your portfolio has more risk than you can handle.
If you excitedly invest every penny you get your hands on every payday, you’re not dollar-cost averaging. You are periodically lump-sum investing.
#2— Passive Income
Rule of thumb: Anyone who talks about “passive income” a lot will likely try and sell you their online course.
I am not sure when it happened, but online influencers have pulled a clever marketing trick where they refer to any online business as “passive income.”
Passive income conjures images of sitting poolside while the cash rolls into your bank account. That is the image that online marketers want to imprint into your brain before they sell you their strategies to build “passive income.”
As I have detailed in the past, what most people refer to as passive income is, in fact, just income from running an online business.
Running an online business has changed my life. But it is not for everyone, and it is the furthest possible thing from “passive”—It’s a lot of hard work with frustratingly slow results.
The only true source of passive income comes from investments like stocks, real estate, and bonds. But as we are about to review, investment income is also badly misunderstood.
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#3—Investment income
The obsession with “passive income” extends beyond online marketers into online investing communities. Specifically, dividend investors want you to be obsessed with passive income from dividend-paying stocks.
The dividend investors, much like the passive income marketers, have a very easy job in selling you on the idea of passive income. What could be more appealing than having all your living expenses covered by passive income?
But as I detail in great length in chapter 15 of The Rational Investor, focusing on dividend-paying stocks is irrational for two reasons.
#1— Dividends are not “free money” they come at the expense of capital gains.
Rational investors care about one thing; total return on investment.
Total returns for stock market investors = capital gains + dividends - investment fees & taxes
Capital gains occur when the share price of the stocks you own increases. The more dividends stocks pay, the less they have to reinvest in the business and grow your unrealized capital gains.
Dividends are tax inefficient—you pay taxes on them every year, even in years you don’t need the dividend income.
Focusing exclusively on dividends reduces your diversification—nearly 40% of global stocks do not pay a dividend.
#2— Realized capital gains are income too
If you want to buy a $500 TV, it doesn’t matter if you get paid $500 in dividends or sell $500 worth of shares, income is income. This is a fact dividend investors choose to ignore.
#4—Stocks always bounce back
In chapter 35 of The Rational Investor, I talk about why long-term rational investors who have a globally diversified portfolio of index funds should not live in constant fear of a market crash.
Why?
Because market crashes—a 50% decline in value—are often followed by sharp rebounds.
A 2018 paper written by William Goetzmann titled “Negative Bubbles: What Happens After A Crash?” examined over 1,000 stock market crashes across 100 different stock markets from 1692-2015.
In the year following a crash, stock markets were twice as likely to provide a positive 25% return than they were a negative 25% return.
Stock markets tend to bounce back after a crash.
This is not true for individual stocks!
I repeat: sometimes individual stocks crash and never recover!
While it is rare that you would lose “all” of your money picking stocks, you will likely lose “most” of your money.
A study conducted by J.P. Morgan looked at all publicly traded stocks in the U.S dating back to 1980. 40% of the 13,000 stocks in the study declined by more than 70% from their peak value and never recovered.
Friends don’t let friends pick stocks.
This article is for informational and entertainment purposes only. It should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions.
Ben, i’m not sure what point you’re trying to make regarding DCA. Dollar cost averaging is simply buying a target security at periodic times regardless of price to reduce volatility impact on purchasing that security. The source of funds whether it’s from a paycheck or from a lump sum inheritance makes no difference if you are dividing your purchases of a target security overtime then you are dollar cost averaging. Yes, I agree it may indicate some thing about the risk tolerance of the investor but that’s all.
Will do both and you have a great one as well.