Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

5 Money Rules That Are Just Plain Wrong

For whatever reason, those of us in the financial industry tend to regurgitate the same investing mantras over and over again, without stopping to think critically about what we're saying. So, I thought it was time to address some of the old "rules" I was taught about money, and why I think it's time to dump them.

If you're not quite ready to chuck this conventional wisdom in the trash, I hope you're at least inspired to take a second look at the financial rules you've adopted to see if they actually make sense for you.  

Here's my list of the flawed money rules I was taught, and the "new rules" that should replace them. If you can think of other money myths you don't understand, or if you disagree with my assessment here, shoot me an email at sara@investinganswers.com to tell me about it.

Old Rule: Take on more risk when you're young.

I started my career almost 10 years ago. And because I was used to living like a college student, I was able to scrape together a little bit of savings every month. Being young and impressionable, I totally bought into the much-touted risk/reward concept that the financial industry is so fond of touting. I don't think I was alone. The idea is so simple: If you take on risk, you will be rewarded.

Like so many other investors, the last decade taught me a powerful lesson in risk vs. reward. So please hear me when I tell you:

Risk is not volatility. It's not price fluctuation. It's the possibility of a "permanent loss of capital." Permanent. Forever. The risk/reward relationship is this: You take on risk with the expectation of being compensated with a greater return. But you could be compensated instead with a permanent loss of capital. That's the trade-off.

And over time, a permanent loss of capital is devastating.

Let's say that it's August 2000, and I've saved up $10,000. I'm in my early 20s, and the conventional wisdom is that I need to take on more risk when I'm young.

Under Scenario A, I say, "Sounds fun! Let's do it!" I'm ready to take some big risks to get big rewards. It just so happens that Fortune Magazine put out a list of "Ten Stocks to Last the Decade," so now I have a plan. I'll split up my $10,000 and buy $1,000 worth of each stock they recommend for this buy-and-hold portfolio: Nokia, Nortel, Enron, Oracle, Broadcom, Viacom, Univision, Schwab, Morgan Stanley and Genentech. All I have to do is wait 10 years (a pretty long time for a 22 year old), and I'll be well on my way to early retirement.  

Under Scenario B, I realize that I'm way out of my element and I have no business investing in companies, businesses, industries and/or countries I don't understand. So I put $5,000 in Vanguard's Intermediate-Term Treasury Fund, which invests in 5-10 year Treasuries, and $5,000 in the Vanguard Total Stock Market Index Fund, which invests in the entire stock market.

Can you see where this thought experiment is going?

After 10 years, my conservative $10,000 portfolio split equally between stock and bond mutual funds is now worth $14,488.

My risky portfolio, 100% invested in the hottest growth stocks of 2000, is now worth $6,745.

But that's not even the worst of it. Here's the impact of that permanent loss of capital over the next 30 years:

Holy cow. Regardless of how fast my money grows during the next 30 years, that's a big penalty for my 62-year-old self to pay for my 22-year-old self following conventional wisdom.

Today, I follow a different strategy. Every dollar I save is precious, and I want to keep it safe. Warren Buffett has two rules of investing. Rule #1 is "don't lose money." Rule #2 is "never forget Rule #1." If the philosophy is good enough for Warren Buffett, it's good enough for me. These days, I place less emphasis on the risk/reward relationship and more on the magical powers of time and compounding.

New Rule: The greater the risk, the greater the opportunity for loss. It's better to rely on old-fashioned compounding so you can take advantage of the most valuable asset you have -- time.

Old Rule: Owning your home is a great investment.

First, a confession: I own my house. But every day I walk up to it, I wish I didn't. I look at it and see a pile of money locked up, yearning to be set free. And my sad pile of money, put there via my down payment, is actually 6% smaller because I know I'll have to pay my real estate agent and the buyer's agent their commissions when I sell.

I'm not the only person starting to question the myth of homeownership. James Altucher just wrote an article he titled, "Why I Am Never Going to Own a Home Again." 
#-ad_banner_2-#In the article, Altucher points out that homes have all the hallmarks of an ugly investment. They are a) illiquid, b) taxable every single year without fail, c) used up over time, and d) a cage.

It takes a lot of time and effort to sell a house, and only if you're lucky will you end up with a buyer who qualifies for financing. You get your property tax bill every year, regardless of whether you receive income or realize capital gains. As it ages, your house will break down and require repairs. And it's not easy to liquidate your "investment" and leave town if you want to, for whatever reason. Those are some serious downsides.

But unlike Altucher, I don't think a house is never a good investment. To see if your house qualifies, ask yourself this: If I was a renter, how much could I rent this house for? Now, subtract your monthly principal, interest, tax and insurance payment (PITI) and multiply by 12. If you're lucky, the number is positive. But if you're like most homeowners, the number is negative. That means you're overpaying to live in your house, and to add insult to injury, you probably have a good chunk of change tied up in equity -- like I do.

Let's walk through an example. Let's say my house would rent for $1,200 month but I pay $1,400 per month in PITI. Each month I'm over-paying by $200 for the privilege of living in this particular house, plus I can't get to the sad pile of money I mentioned earlier.

Now let's say I could rent out my house for $1,600. Under this scenario, I "make" $2,400 per year because I'm essentially renting myself my house for $200 less than I would otherwise pay. If I divide that by my equity investment (let's assume I have $48,000 in equity) I can calculate my "dividend yield:" $2,400/$48,000 = 5%.

That's not too bad. But only by thinking of a house in rent-equivalent terms does it make sense to consider it an investment. And, just so you know, there aren't too many housing markets where the rental equation works out in favor of the owner, at least right off the bat.

I'm not anti-real estate as an investment. I just believe the value equation needs to work out. One of the best pieces of investing insight I ever heard (I think it was investing heavyweight James Grant) was something along the lines of, "There are no bad assets, just bad prices."

New Rule: Like anything else you invest in, a house you buy at a good price can be a good investment. But it's not automatic.

Old Rule: Pay off your mortgage as soon as possible.

The sister-advice to "your home is a good investment" is, "pay off your mortgage as fast as you can." The reasoning behind it is this: By paying off your mortgage, you end up minimizing the interest that goes in the bank's pocket. Plus, once you pay off your mortgage, your housing expense is eliminated. 

There are a couple flaws in this logic. First, whether you own or rent, you have a housing expense. If you own a house outright, you're not receiving interest or dividends from the money you have invested in your home, and that lack of income is an opportunity cost that you're incurring. And if you own a home with a mortgage, you have interest expense. You are incurring an expense, regardless. It shouldn't really matter who that expense is being paid to.  

So if you have a mortgage, I encourage you to use a calculation I come back to time and time again: after-tax mortgage interest rate = annual mortgage rate x (1 - your marginal tax rate). This will give you the after-tax interest rate on your mortgage debt, which can help you decide whether there's a benefit to paying back your mortgage faster. Let me explain.

If you have a mortgage at 6%, and you're in the 25% tax bracket, your effective interest rate is 4.5% because you get to deduct interest expense on your tax return (after-tax rate: 6% (1- 0.25) = 4.5%). On its own, 4.5% is neither good nor bad. It's just a number. But it becomes really important when you think about other investing opportunities out there.

If you pay 4.5% on your mortgage, can you find any other investment out there that will earn you more than 4.5% after taxes? If, instead of paying off your mortgage, you put your savings into your Roth IRA and find an investment that pays you at least 4.5% per year, and is more liquid to boot, isn't that a net gain to you?

Yes. 

Conversely, if you can't find a reasonable investment that pays you more than 4.5% per year, it makes sense to pay down your mortgage. The 4.5% is your own personal "hurdle rate."

By the way, this equation works for student loans, too. Knowing your hurdle rate allows you to put your savings where they do you the most good. If your mortgage rate or student loan rates are high, it might make sense to pay them off early. But if not, you can probably do as well, if not better, investing in fairly safe bonds or dividend-paying stocks. 

New Rule: Don’t be seduced by the prospect of zero rent if the return on your investment will yield more elsewhere.

Old Rule: Start saving for your child's education right away.

Ok, another confession. I don't have any children. But I do have parents, and they did not pay my college tuition. Are my parents bad parents? No. Am I still paying student loans 10 years later? Yes. Is it the worst thing that's ever happened to me? No. I made the investment, and now I'm theoretically reaping the reward via higher earning potential. Sounds fair to me.

This is how I think of it: If a college education is an investment, it's only an investment for the person in college, right? We invest in college because we want a chance to make more money in the future. But if you're making the investment, and your kid gets the payoff, I don't understand how to calculate your return, at least monetarily.

In this article, we're talking about investing, not philanthropy, and paying for your child's college education sounds more like a really expensive gift than an investment. And it becomes a huge problem when really expensive gifts are given by people with shorter saving timelines to people with much longer saving timelines. It's completely backwards. Parents who rely on their children for support in later years are a much larger financial liability than the largest student loans. And that doesn't even take into account the emotional liability. I would not feel good if my parents struggled through their golden years because they spent all their savings sending me to college.

New Rule: First decide whether you can really afford it or whether it's actually a sacrifice. If you're in a position to give your kids such an expensive gift, then go for it. Just remember that people can take out loans for college, but they can't take out loans for retirement.

Old Rule: You must put your cash to work.

Cash, even at today's yields, is not worthless. Cash is a safety net and a stash of dry powder that can be used to scoop up incredible opportunities. And here's a little secret: The Fed has purposely set short-term rates at zero because they want you to take on risk, and hopefully, jumpstart the economy. Sound risky? It is. Any time the government is "encouraging" you to do something as a matter of public policy, be wary. Remember how that "culture of homeownership" worked out for millions of homeowners? Not great.

One of my very favorite investors and writers, James Montier, puts it this way: "Be patient and wait for the fat pitch." Having a stash of cash on hand will enable you to pounce when those "bad prices" mentioned earlier turn into "good prices." So don't feel bad about leaving some percentage of your portfolio in cash. When the bargains start appearing, you'll be glad you did.

New Rule: Cash is still king. Hold onto yours like a lifeline and wait for a golden opportunity. Opportunities always come up -- make sure you're ready to take advantage of them.