Debunking 4 Common Investing Myths

Following the Biden administration’s establishment of a 1% excise tax on share buybacks as part of the Inflation Reduction Act, chairman and CEO of Berkshire Hathaway Warren Buffett had some sharply pointed thoughts to offer on a pernicious investing myth.  Berkshire itself has used share buybacks extensively over the years. In 2021 alone, the company spent $27 billion on them. 

Buffett didn’t mince words on the topic in the company’s annual letter to shareholders, stating:

When you are told that all repurchases are harmful to shareholders or to the country, or particularly beneficial to CEOs, you are listening to either an economic illiterate or a silver-tongued demagogue (characters that are not mutually exclusive).

Buffett is not alone in his thinking. Many financial market participants regard share buybacks as being an appropriate use of shareholder funds, especially when a company does not see good investment opportunities where it could otherwise deploy the capital. Cash on the balance sheet tends to burn a hole in a CEO’s pocket. Surely it is better that this cash be returned to shareholders rather than splurged on an unwise acquisition, right?

Unfortunately, share buybacks are one of many examples where there’s a disconnect between the narrative offered by talking heads, public perceptions, and reality. Let’s break down some of the common points of contention and recalibrate our understanding.

MYTH: Share Buybacks Are About Greed

Opponents of buybacks contend they are a sign of corporate greed run amuck. At the top of the food chain, they argue companies issue large amounts of stock as bonuses to senior executives, which the companies then buy back in the market to avoid dilution.

They further insist that buybacks primarily benefit already wealthy shareholders by increasing a company’s share price. In theory, by reducing the number of outstanding shares, the company’s future earnings will be spread over a smaller number of shares, increasing the per-share value. 

Why is that a bad thing? Opponents feel such capital would do more good by being invested in the business helping to generate new employment opportunities or improve wages for existing employees. 

It’s a nice thought, but it’s largely disconnected from reality.

Why It’s a Myth

This investing myth ignores the effect of the buyback on the company’s overall enterprise value. Long-standing research by Modigliani and Miller finds that changes in a firm’s capital structure cannot change its value. If the repurchased shares are paid for with cash sitting on the company’s balance sheet, the company’s enterprise value falls by the same amount. If the shares are paid for with cash generated by issuing debt, then the company’s leverage has increased. 

Such corporate actions may temporarily influence the company’s share price due to market sentiment and irrational investors. But in neither case does the buyback increase the value of the company’s shares.

Furthermore, keeping high-performing executives and shareholders happy is not an inherently bad thing. None of them got into the game out of the goodness of their hearts. They want a return on their investment, whether it was in dollars or work. Keeping them happy keeps their efforts and capital invested, which ultimately creates room for more meaningful long-term employment and wage expansions. 

MYTH: Dividend Stocks Create Greater Value

As investors grappled with the dual-edged sword of high inflation and rising interest rates last year, they flocked to an old favorite: dividend stocks. These stocks ran hot in 2022, with inflows of more than $48 billion. Despite outflows in January, surveys show this trend is likely to persist, with 30% of investors reporting dividend stocks as their primary focus in 2023. 

The market has responded to growing demand by offering new products. S&P Global, for instance, created an index of “Dividend Aristocrats.” It tracks the performance of companies that have increased their dividend every year for the last twenty-five years, consecutively. Eager to capitalize on investor trends, a number of other companies subsequently launched mutual funds and ETFs focused on buying the stocks of these Dividend Aristocrats.

Why It’s a Myth

Investor preference for dividend-paying stocks is nothing new, but that doesn’t make this investing myth justified. Once again, Modigliani and Miller explained theoretically why dividend policy is irrelevant to stock returns. Subsequent empirical research affirmed their conclusion, demonstrating that there is no alpha among dividend-paying stocks.

This is not to say investing in dividend stocks is a bad thing. After all, 40% of stock returns since 1930 have been generated by dividend stocks – a number that rises to 54% during inflationary periods. The point is that they do not generate preferable returns because they are dividend stocks.

Public misconceptions about dividend stocks, however, may fuel a counterproductive investing mindset in the long term. As an article in the Chicago Booth Review explains:

Investors caught up in the free-dividends fallacy mistakenly view dividend-paying stocks as bond coupons that produces small, stable gains over time. When investors trade based on a stock’s performance, they focus on whether the stock has gained or lost money relative to the purchase price. Ignoring the impact of dividends, they focus on price changes, not total return. However, investors who want to receive a dividend stream need to hold on to the stock until it pays out its regular dividend, and Hartzmark and Solomon find that investors tend to hang on to dividend-paying stocks for longer periods of time, regardless of performance.

Because investors with this mind-set keep dividends in a separate “mental account,” they rarely reinvest dividends in the companies that paid them. Instead, investors, including large mutual funds and institutions, tend to use the payouts to purchase other stocks.

In other words: investing in dividend stocks is not necessarily bad or good. The investing myths around them, however, are absurd. Whether it’s a smart play depends on your approach and reasoning.

MYTH: A 60/40 Portfolio is Safest (or dead)

Financial advisors have applied Modern Portfolio Theory (MPT) in their clients’ portfolios for years. The most generic version of this is a 60/40 portfolio. They are typically comprised of a 60% allocation (by market value) in equities like stocks and 40% in fixed-income securities like bonds. 

Advisors and investors gravitate toward such portfolios because of their supposed lower volatility. Though data demonstrates that long-term equities will outperform bonds over time, a pure equity portfolio is vulnerable in the event of a sharp selloff in stocks. These selloffs tend to generate a “flight-to-quality” and to high-quality bonds. 

This, in theory, increases the value of the bond portion of a 60/40 portfolio, providing a hedge against losses on the equity portion. But with US government bonds losing more value even than the equity market in 2022, many speculated as to whether the strategy still had merit.

Why It’s a Myth

Both staunch proponents of the 60/40 portfolio and its detractors are wrong. 

First, reactionary criticism of 60/40 portfolio performance stems from a short-term perspective. Were the returns rough in 2022? Yes. But back-testing the performance of various investment portfolios over the last 30+ years until 2021 shows that a 60/40 portfolio consistently demonstrates good risk/reward characteristics over time. A bad year doesn’t make for a bad long-term portfolio management strategy. 

Second, our assumptions about market dynamics stem from a past that looks different than the present. The 60/40 portfolio typically delivers strong results during periods when interest rates are falling. By 2021, rates were already historically low and recently issued bonds had correspondingly low coupons. This meant more cash flow came more from the final redemption at maturity than from the coupons, undermining the logic behind a 60/40 allocation strategy. Portfolio returns suffered as a result. That’s why 2022 was so tough for 60/40 portfolios.  

Though interest rate hikes from the Federal Reserve are unlikely to abate anytime soon, it’s important to remember that economic conditions tend to be cyclical. So if you approach investing from a long-term perspective, a year of rough performance isn’t enough to make the strategy worthless. It just means it’s not a foolproof way to hedge your bets.

The principle behind MPT remains true: diversification is the bedrock of crafting a successful investment portfolio. What 2022 tells us about this principle, however, is that diversification looks different in different economic climates. Depending on where you are in your financial journey, safety plays like bonds might not be the best option for you. With a wide variety of alternative investment options available, it may be worth considering different avenues for managing your risk exposure.

MYTH: Rising Interest Rates Gut Stock Value

Consider this point the flipside of the flawed thinking about 60/40 portfolio viability. Many market commentators (including those who oughta know better) write that when fixed-income yields fall, the decline in the rates used to discount the expected future cash flows of equities means that the net present value of the cash flows rises. This, they contend, drives higher stock prices in the near term. 

Distilled, this is a reflection of MPT’s theoretical justification in practice: stocks go down when interest rates (and, by extension, bonds) go up. Today, of course, the conversation revolves around the inverse. With interest rates climbing ever higher, we should expect the net present value of cash flows to decline, hurting stock value.

But not so fast! Further examination reveals this investing myth is not economically nor mathematically coherent.

Why It’s a Myth

Suppose that we start in a world where interest rates and the expected future cash flows from stocks are internally consistent. In these circumstances,  falling interest rates would mean expectations for future inflation and economic growth have fallen, too. This would indicate we should lower our expectations for the future cash flows to be generated by stocks to be consistent with that expectation for lower future economic growth.

When you discount these lower future expected cash flows with the lower discount rate you no longer produce a higher net present value. To argue higher or lower interest rates cause stock values to rise or fall on their own requires some seriously fuzzy logic.

“Truisms” Aren’t Always True

So much of the public’s understanding of finance stems from nuggets of “wisdom” picked up along the way. But just because an investing myth is widely accepted as true does not make it so.

The pace of financial innovation and market evolution offers investors more opportunities to profit than ever before… and more opportunities for loss. Those who want to make sure their investment philosophy keeps up with this pace would do well to re-examine their own assumptions about how their thinking still works (if it ever did).

Now that you’ve shaken off the shackles of investing misconception, it’s time to make sure you’ve got the right foundation for evaluating future investment strategies. The following on-demand webinars from Financial Poise offer a great starting point:

• All About Asset Allocation
• Goal-Based Investing – Planning for Key Life Events
• Alpha, Beta, and Other Key Concepts

And there’s more where that came from! For more information about our on-demand webinar series, click here.

©2023. DailyDACTM, LLC d/b/a/ Financial PoiseTM. This article is subject to the disclaimers found here.