Over the course of my career at Parametric, I’ve had the pleasure of discussing the finer points of investment strategy with a wide range of clients, consultants, financial advisors, and colleagues. Most have asked great questions, challenged my own thinking on certain matters, and made me better at my job. For that, as I prepare to leave the firm after more than nine years, I’m thankful.
But what’s stuck with me just as much over the years are the investing misconceptions I’ve encountered—and continue to encounter. Those who know me best also know that disproving those investment myths is what really gets me out of bed in the morning. And so, in my final blog post, I’ll try to address what I believe are the top four misconceptions about investing that, if I could, I’d erase from investors’ brains. Here they are, in ascending order of annoyance.
4. Taxes don’t change investment outcomes all that much
This concept may have arisen from the fact that for most active investors at the dawn of the investment management industry, taxes really didn’t matter, since pension plans, endowments, and foundations enjoy tax-free status. As such, most investment processes were fine-tuned to produce pretax alpha, with little regard for the tax impact of rapidly turning over a stock portfolio.
However, over the past two decades, research has shown that most, if not all, of this pretax alpha is erased once taxes are taken into consideration. While reflecting taxes introduces a great deal of complexity into calculating returns for investors, to simply say taxes have only a minor impact on investment returns, but not actually calculate them, is disingenuous at best. This is especially true given that the bulk of retail assets are held in taxable accounts.
3. Concentration equals outperformance
There are many ways this common misconception about investing surfaces, from the seeming consensus that a high-conviction, concentrated stock portfolio is the only “right” way to generate excess returns to the more recent absurd focus on high “active share” scores by numerous regulatory bodies. While concentration can be a good way to get rich (just ask Bill Gates or Jeff Bezos), it’s also a quick way to get poor (as employees of Theranos and General Electric can probably tell you).
Similarly, building a concentrated stock portfolio is certainly a good way to generate outperformance, but there’s no guarantee it won’t generate massive underperformance. Simply put, just being concentrated isn’t proof of investment skill. And as Parametric has shown, there are other ways of generating excess returns that don’t depend on concentration.
2. Dividend yield and bond yield are comparable
I worked for a portion of my career in fixed income, and I’ve heard this canard often. It’s an apples-to-oranges comparison. Bond yield is the internal rate of return that equates the present value of the known cash flows of a bond with its current price, while dividend yield is simply the ratio of an estimated dividend payment of a stock to its current price. Just because we call them both “yield” doesn’t make them comparable—for example, dividend payments aren’t contractually guaranteed, while bond coupons are.
There’s also that little matter of getting your par investment back at a bond’s maturity, whereas no one knows what the stock price will be at a future date. But industry convention is to put these two numbers side by side and say things like “AT&T is outyielding the 10-year Treasury,” despite the very different set of risks you take on when you make each investment.
1. Higher risk means higher return
Every time I hear someone say, “Emerging markets will get a higher return because they’re riskier,” I want to scream. If this were true, then asset allocation would be a very simple task—just allocate all your money to the riskiest asset class.
Sadly, taking on more risk doesn’t guarantee higher returns—it guarantees higher expected returns. That is, the asset class has an assumed average return that’s higher than a less risky asset class. The higher expected return is needed to induce investors to allocate capital to these risky asset classes, but by their very riskiness these asset classes can disappoint. This latter point has been vividly demonstrated by the less risky US stock market outpacing all the more risky emerging market countries’ equity markets over the past decade.
I’ve been told this investing misconception has its origins in the early 20th century, when the investment universe in the US was more limited and stock dividends were more prevalent. At that point the yield on government bonds was lower than that on corporate bonds, which were in turn lower than the yield on stocks. These increased payouts could then be combined with an investor’s perception of the increased riskiness at each step to make an investment decision. That is, the investor inherently weighed an increased payout versus an increased risk of being completely wiped out by a company’s failure. Somewhere in the intervening period this nuance has been lost, but investors would be wise to remember it.
The bottom line
I don’t mean to sound like a curmudgeon. Despite the persistence of these four common misconceptions about investing, the industry is full of very smart and thoughtful people. I’ve met a dizzying array of individuals with an equally wide range of opinions and views on the market, but the consistent thread through all my conversations has been an attempt to benefit the end investor. And for that, I’ve also been grateful. I wish you all good luck in the future.
Tim Atwill, PhD, CFA, Head of Investment Strategy (emeritus)
Mr. Atwill leads the Investment Strategy team at Parametric, which is responsible for all aspects of Parametric’s investment strategies. In addition, he holds investment responsibilities for Parametric’s emerging market and international equity strategies, as well as shared responsibility for the firm’s commodity strategy.
The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Parametric and its affiliates disclaim any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Parametric are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Parametric strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results. All investments are subject to the risk of loss.