Financial Advice which is Totally Bogus but Often Given

We’ve all heard one form or other of the following bit of financial advice: “You should only invest in the stock market if you are going to leave your money in it for a long time.”

It sounds sensible, but it is utter nonsense. You don’t need to know anything about finance, or about math, to see that it is nonsense.

Consider a slightly more specific statement of this advice “If you have a certain sum of money you are considering investing, you should invest it in the stock market if and only if you plan to leave it there for more than 5 years.” (You can find an example of this advice here, if you replace “5 years” with “10 years.” In this instance the advice is given by the founder of the Vanguard Group, who should know better. Here is another instance.).

To see that it is nonsense, consider it in the context of a short screenplay which I have written about the interaction between an investor and his foolish financial advisor:

———————————————

The year is 2011. The investor walks into his financial advisor’s office.

Investor: Hi. I have just won $10,000 in the lottery. Should I invest it in the stock market, or should I put it in a savings account?

Advisor: It depends on when you plan to spend the money. You should put it in the stock market if and only if you plan to take it out of the market more than 5 years from now.

Investor: I plan to spend it in 7 years, in 2018. I’m going to buy a house at that time.

Advisor: Ok, then, since 7 > 5, you should invest that money in the stock market.

Investor: Great, thanks!

3 years pass. The investor walks back into his advisor’s office to discuss his finances.

Investor: Hi. I want to check up and make sure I am doing the right thing with my money. 3 years ago you told me to invest $10,000 in the stock market, and I followed your advice. Should I leave it there?

Advisor: When do you plan to spend it?

Investor: I plan to spend it in 2018, as I told you 3 years ago.

Advisor: That is only 4 years from now. Since you should only invest money in the stock market if you plan to leave it there for more than 5 years, and since 4 < 5, you should pull your money out of the stock market. (Neglecting taxes and transaction fees, your decision about whether to keep your money in the stock market is equivalent to the decision about whether to put into the stock market money which is not currently in the stock market. Since you shouldn’t do the latter with only 4 years to go, you shouldn’t do the former.)

Investor: But that doesn’t make any sense! You originally suggested I should invest my money in the stock market for 7 years. Why are we abandoning your plan midstream?

Advisor: We are just re-applying the same advice I originally gave you, which is that you should only have money invested in the stock market if you plan to leave it there for more than 5 years.

Investor: But that advice clearly doesn’t work! 3 years ago, that advice suggested I should leave my money in the stock market for 7 years, and now it suggests that I should pull it out after only 3. It seems to me that as long as we are living in a universe in which time passes, rather than standing still, your advice is self-contradictory.

Advisor: I don’t get it.

Investor: You’re fired.

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10 Responses to Financial Advice which is Totally Bogus but Often Given

  1. Julian says:

    I read the Little Book of Common Sense Investing, and your hypo does not resemble my recollection of his advice. It also seems to me that you’ve plucked one stupid thing he said from one interview, and on the basis of that thing you’re discarding a large theory. People love round numbers, and I don’t know what justification, if any, Bogle had for picking “ten” out of the air, but he didn’t do that in the one book I read. In the book, and indeed in an earlier part of the interview, he says you would ideally keep your investment forever. His book was much more convincing than the linked interview.

    Bogle spent the whole book retreading one point: if you invest in the entire marketplace and just hold that investment, you will earn returns which beat the returns earned by most hedge funds and other similar financial experts. Sometimes this is because of the transaction costs you incur with financial services people. Other times it’s because the financial services people get especially unlucky. I can’t move my puppy’s crate to see if I have the book on my shelf, but I do recall the that the data he provided showed (to me, but I have no expertise) that the S&P or some other such index, over time, consistently outperformed financial services experts.

    I think that Bogle says the main reason indices beat experts is that since your returns can be compounded by reinvesting in an index, steady growth is hugely beneficial because you more rarely miss an opportunity to reinvest. More volatile investments cut into your ability to compound your returns. As for proof, I don’t know where to find it (besides in his book), but the data did convince me.

    His strategy reminds me of this statistical fallacy:

    You have a circle with an arrow fixed to the center. 70% of the circle is red, 30% of the circle is green. The arrow, when spun, has a 70% chance of landing on a red portion of the circle and a 30% chance of landing on a green portion. I’ve read that in actual experiments wherein volunteers are asked to attempt to accurately predict what color the arrow will point to after being spun, people overwhelming say that their strategy will be to pick 70% of the time and green 30%. Of course, this yields (70% of 70%) + (30% of 30%) or a 58% success rate. If they just guessed red every time, they’d be right 70% of the time.

  2. Julian says:

    Two more things:

    one, can you cite the part of the interview where he implies or states that you should behave as the advisor in your hypo behaves?

    and two, this:

    “(Neglecting taxes and transaction fees … ”

    elides over a big issue.

  3. Jonathan says:

    I know absolutely nothing about Bogle, so if he is usually very smart and helpful, and it is only in this case where he is peddling bad advice, then it is just bad luck for Bogle that this happens to be the interview of his that I googled.

    Here is the quote I am referring to from this interview:

    “If you said ‘What kind of a time horizon should I have to be in the stock market?’ If you are not in the stock market, I would say 10 years. If you are going to be in the stock market for less than 10 years, I wouldn’t do it; it is too unpredictable, too fraught with speculation.”

    You might note that he says “If you are not in the stock market,” thus suggesting that it matters whether you currently are or are not in the stock market. Clearly this is not true, neglecting taxes and transaction fees.

    Which brings me to that issue. I would say that transaction fees are unequivocally a small issue. If I am not in the stock market, and I want to get in, and if I want to follow the rest of Bogle’s advice, I should just invest in the S&P 500 ETF (or something similar), which will cost me about $7.95. So I will be $7.95 poorer than I would be as compared to the person who was already invested, with the same amount of money, in that fund. Thus, whether I happen to be in the market or not is as irrelevant as $7.95 is from a transaction fees perspective.

    The tax issue, although it is not completely insignificant (as the transaction fee issue is), does not make the advice in question any more excusable, all it does is muddle this issue slightly by making it impossible to make categorical statements about what someone should do with this money without knowing his tax issues. The tax issue can go work both ways (as far as informing a decision about whether to sell out of the market or not), so a financial advisor has no ground to stand on if he says that it, in general, provides the crucial difference between a person with $10,000 in the market and a person with $10,000 in cash, who’s thinking of investing (and I have never actually heard a financial advisor claim that tax effects are the reason they are providing this advice in the first place). The person with $10,000 in the market may have a tax burden associated with that money, which should make him more inclined to stay in the market, or he may have a tax benefit, which should make him more inclined to pull out.

  4. Jonathan says:

    Actually I just realized that, at least with Fidelity, you can invest in ETFs (exchange traded funds) for free, so I should correct my last comment by saying that transaction fees would be 0 in this example.

  5. Julian says:

    I know where Bogle mentioned the 10-year horizon, I do not know where he states that you should behave as the advisor in your hypo behaves (as though he does not understand that the passage of time does not reset clocks).

    In your hypo, the financial advisor behaves as though he doesn’t understand the flow of time. Where does Bogle say that if you plan to invest for 10 years, after 1 year of having money in the stock market, you should pull your money out because you now have less than 10 years left?

    “Which brings me to that issue. I would say that transaction fees are unequivocally a small issue. If I am not in the stock market, and I want to get in, and if I want to follow the rest of Bogle’s advice, I should just invest in the S&P 500 ETF (or something similar), which will cost me about $7.95. So I will be $7.95 poorer than I would be as compared to the person who was already invested, with the same amount of money, in that fund. Thus, whether I happen to be in the market or not is as irrelevant as $7.95 is from a transaction fees perspective.”

    Notice that the transaction fee is trivial in this example precisely because you have followed Bogle’s advice. You have made one trade that allowed you to invest in the S&P and then you’ve made no further trades and incurred no further fees. Bogle is arguing that very active trading incurs fees (guaranteed losses) that more than erase the gains typically made by hedge fund managers and others like them.

    I think you have suggested that Bogle is saying that transaction fees are a reason to not invest in an index, but that is wrong. Bogle is saying (in his book, if not in his interview) that transaction fees are a reason to invest in indexes (indices?) and to NOT invest in high frequency trading funds, where you incur many transaction costs.

  6. Julian says:

    I said “high frequency trading” but I should have said “higher,” I think high frequency trading is a term of art.

  7. Jonathan says:

    “Where does Bogle say that if you plan to invest for 10 years, after 1 year of having money in the stock market, you should pull your money out because you now have less than 10 years left? ”

    He doesn’t make that statement. Instead, he makes the statement “You should invest in the stock market if you plan to have your money there for more than 10 years.”

    The following fact renders that statement internally inconsistent in a universe where time does not stand still:
    Fact: The decision about whether to invest or not, today, is equivalent to the decision about whether to keep money (which is currently invested) invested or not (neglecting taxes & transaction fees, issues I dealt with above).

    The purpose of the screenplay was to show that inconsistency.

    “I think you have suggested that Bogle is saying that transaction fees are a reason to not invest in an index”

    If I have suggested that, I am a much less clear writer than I thought I was, and I’d like to know where that suggestion was made. I totally agree with Bogle on the wisdom of investing in indices, both because of the low transaction costs and because they’re likely to perform better than whatever some fund manager wants to sell you.

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  9. Julian says:

    I thought you said transaction fees are not significant here, in your 8/9 7:25 comment:

    “Which brings me to that issue. I would say that transaction fees are unequivocally a small issue. If I am not in the stock market, and I want to get in, and if I want to follow the rest of Bogle’s advice, I should just invest in the S&P 500 ETF (or something similar), which will cost me about $7.95. So I will be $7.95 poorer than I would be as compared to the person who was already invested, with the same amount of money, in that fund. Thus, whether I happen to be in the market or not is as irrelevant as $7.95 is from a transaction fees perspective.

    The tax issue, although it is not completely insignificant (as the transaction fee issue is)”

    I could not understand why you were pointing out that paying $7.95 to invest in an index is a trivial cost, unless you thought Bogle had argued otherwise. I assumed from your argument that you believed someone was arguing the other side.

  10. Jonathan says:

    I argued that transaction fees are not important because they *do* represent a difference between buying into the market and staying in once you are already in, thus they need to be dismissed as a possible justification for treating the decision to buy in differently from the decision to stay in.

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