Financial Fact vs Fiction: Why Your 'Magic Number' Isn't Actually Magical

Editor's note: This is part two of a four-part series exploring financial fact vs fiction. Each article will examine five of the top 20 most common financial myths — from investments to retirement and Social Security to life insurance. Part one covered the first five: This Roth Conversion Myth Could Cost You.

In life, we turn to our friends and family for all sorts of advice, but financial advice is best left to the experts, as many pearls of wisdom no longer ring true (or were never very accurate to begin with).

In this series, we are taking aim at the 20 most common financial myths, debunking fact from fiction and providing necessary nuance around conversations concerning investments, retirement, Social Security and taxes.

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Here are the next five on the list:

6. Investing into a broad market index such as the S&P 500 or Nasdaq means that I'm adequately diversified.

A lot of investors assume that if they have their money in an index, such as the S&P 500 or the Nasdaq, that they're broadly diversified. Unfortunately, that misconception couldn't be further from the truth.

If investors are in an index fund that is market-cap weighted, such as these two indexes, it means that money flows predominately to massive companies such as the Magnificent 7 — Apple (AAPL), Alphabet (GOOGL), Microsoft (MSFT), Amazon.com (AMZN), Meta Platforms (META), Tesla (TSLA) and Nvidia (NVDA) — and they aren't adequately diversified.

Currently, the Mag 7 stocks constitute roughly 34% of the S&P 500. In 2023, while the S&P 500 was up 24%, collectively the Mag 7 stocks were up 76%, and in 2024, the Mag 7 accounted for 53% of the S&P 500's total return of 23%.

But now that these stocks are becoming more volatile, investors are rightly worrying about concentration risk — putting too much into the top of the capitalization stack. After all, over the past several months, the performance of the broader market, including international stocks, has started to outpace the big tech stocks.

To achieve true diversification, investors must think about both concentration and participation.

Participation is the percentage of market index members driving returns. In the first half of 2024, percentages were low, with only 25% of S&P 500 companies outperforming the index, but in the second half of the year, participation rates increased, with 57% of constituents outperforming the index, which is well above the 30-year average.

To increase diversification, investors can buy individual stocks or exchange-traded funds (ETFs) that track the S&P index using an equal weighting. They can also invest in quality-factor indexes, which sort the top 50 or 100 companies according to strength of balance sheets, return on investment or equity and growth in sales and earnings while weeding out the weaker companies.

Ultimately, to achieve broader diversification, you should ensure that your investments aren't limited to the two U.S. indexes and include small or mid-cap companies, value stocks and international indexes, both in developed and emerging markets.

7. Retirement planning focuses on how much savings you'll need to accumulate by a future date on the calendar.

Years ago, there was an advertising campaign that asked people: What's your number? It referred to the amount you needed to have saved and invested to retire without running out of money. This isn't just a simplistic way of looking at retirement, it's also extremely antiquated.

First, there is no magic number. Financial professionals project out cash flows every year for the next 40 years. In retirement, people don't get a constant 7% in interest for the next 30 to 40 years, so planners create year-by-year models and then run different stress-test scenarios:

• What if inflation is 3.5% or even 5%?
• What if Social Security gets cut?
• What if returns are only 5%?
• What if there's a 30% sell-off the year you retire?

The goal is to have a good safety net, but ultimately, it's up to the client to determine how much cushion they want to have in retirement.

Second, retirement isn't typically a singular date on the calendar. Unlike our parents and grandparents, most Americans don't work one job for 40-plus years and then retire with a gold watch.

After retirement, some people still work part time, or maybe they work at a modified capacity well into their 70s or 80s.

Retirement looks different for everyone, especially considering that the average U.S. life expectancy has increased by six years over the past half century and employer-funded pensions have largely disappeared.

8. Bonds lose value only when issuers such as Lehman Brothers or Enron go bankrupt and stop paying or default.

Many investors assume that bonds are inversely correlated to stocks, so if stocks sell off by 35% to 40%, bonds will go up to cushion those stock losses.

Unfortunately, that assumption isn't completely accurate. Stocks and bonds can be inversely correlated, but they aren't always, especially for retirees holding high-yield bonds.

There are two risks associated with bonds: credit quality and interest rate risks. In 2022, stocks and bonds were both down by double digits because of interest rate risks — the Fed started raising interest rates, which were low for a long time. When interest rates go up, the value of an existing bond goes down and vice versa.

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We tend to think about bonds as being the least risky asset, but owning a bond isn't like having a CD with guaranteed 6% interest, so it's important to be aware of all the risks when considering potential investments.

9. My effective income-tax rate will drop significantly when I retire and enjoy the 'golden years.'

Sometimes retirement puts you into a lower tax bracket, but not always.

For many retirees, once they start taking required minimum distributions (RMDs), they find themselves in the same or even a higher tax bracket when factoring in income and dividends from their taxable investments, along with their RMDs being taxed as ordinary income.

If you haven't been able to save and invest much for your retirement, you'll probably be in a lower tax bracket when you retire. But remember: If you've been keeping all your savings in a traditional, pretax account, distributions are taxable just as if you earned them through an employer.

Additionally, 50% to 85% of Social Security income is taxable, so between Social Security and RMDs, many new retirees are in a fairly high tax bracket for at least a portion of their retirement, which is a "good" thing, in a sense, because they've done their job saving for retirement.

10. Buying shares of a company paying 4% annual dividends is better than buying a 3% CD or money market account.

If this were true, why would anyone put their money into a CD or money market account?

When you're investing in a stock, you must consider volatility because the principal could be unstable or risky compared to the alternative. Maybe an investor gets $4 in dividends for that $100 stock she bought, for example, but if the share price drops by 15%, or $15, she's still underwater for the year by $11.

If you're not digging deep enough and only considering dividends, you may be accruing more risk than you otherwise thought.

Few things in life are black and white. When it comes to money, it's important to look at the complete picture, weighing the potential risks and opportunities based on a person's individual situation and goals rather than relying on outdated truisms that weren't always true to begin with.

Scott McClatchey is a senior wealth advisor and certified financial planner with Ballast Rock Private Wealth, an SEC-registered investment advisor.

Certain economic and market information contained herein has been obtained from published sources prepared by other parties, which in certain cases has not been updated through the date of the distribution of this letter. While such sources are believed to be reliable for the purposes used herein, Ballast Rock Private Wealth does not assume any responsibility for the accuracy or completeness of such information. Further, no third party has assumed responsibility for independently verifying the information contained herein and accordingly no such persons make any representations with respect to the accuracy, completeness or reasonableness of the information provided herein. Unless otherwise indicated, market analysis and conclusions are based upon opinions or assumptions that Ballast Rock Private Wealth considers to be reasonable.

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