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Smoke-and-Mirror Finances
Need a Calculating Intellect

By JONATHAN CLEMENTS
Staff Reporter of THE WALL STREET JOURNAL

It isn't what it seems.

Folks often proclaim that they made a ton of money on their home, that it's a cinch to score big gains in the stock market and that you can't lose money if you hold bonds to maturity. But dig a little deeper and what you find are some dangerous financial illusions at work.

Don't believe me? Let's take a closer look at each of the above propositions:

Beating the House

Suppose you buy a $200,000 house and sell the place eight years later for $300,000. A handsome $100,000 profit? Lots of folks will tell you so. But in truth, your profit would be nowhere near $100,000.

Think about all the expenses you would incur over the eight years. There are the closing costs when you first buy the house and the broker's commission when you sell. There are also hefty annual expenses, including maintenance costs, homeowner's insurance and property taxes.

Last, but hardly least, there are those pesky monthly mortgage payments. If you put down $40,000 on your $200,000 home and borrow the other $160,000, you would fork over $97,000 in mortgage payments over the next eight years, assuming you took out a 30-year mortgage at a fixed 6.5% interest rate.

Where did that $97,000 go? Over the eight years, you would pay off $18,000 of the $160,000 borrowed, while incurring almost $79,000 in interest.

Even if you can deduct that mortgage interest at a 27% income-tax rate, your out-of-pocket cost would still be $57,600.

The bottom line: That $100,000 profit is nothing more than a financial illusion. In fact, there is a decent chance you didn't make any money at all.

That doesn't, however, mean homes are a bad investment. During the years you owned the house, you didn't have to pay any rent. But boasting "I lived rent-free for eight years" doesn't have quite the same ring as "I made $100,000 on my house."

Watching the Winners

Every year, there are stocks and stock mutual funds that clock dazzling gains. For instance, even as the major stock-market indexes posted double-digit losses in 2002, there were 19 individual stocks that climbed more than 200% and 18 stock funds that were up over 50%.

Not surprisingly, investors see these huge gains and conclude it is easy to score handsome stock-market profits. After all, all you need to do is pick one or two of the winners and you are assured of great returns, right? As investors try to hit the stock-market jackpot, they do the craziest things, trading like dervishes, betting heavily on dicey stocks and plunking their entire nest egg in a few high-octane stock funds.

But in fact, the market's big winners are a sign that the odds are stacked against performance-hungry investors. How so? Because a minority of stocks notch outrageously large gains each year, their performance skews the stock-market average upward, so that most stocks end up lagging behind the average. Similarly, in most years, a majority of funds trail behind the average for all stock funds, because that average is skewed upward by a few funds with eye-popping gains.

The implication: It may seem easy to select winning investments. But in fact, it is a financial illusion. If you try to pick market-beating stocks and stock funds, the odds suggest you will end up with investments that lag behind the market.

The odds are even steeper, once you figure in mutual-fund expenses, brokerage commissions and other investment costs. As investors fixate on the market's big winners, they tend to overlook these costs. Why worry about losing two or three percentage points a year to investment costs if you expect to earn annual returns of 20%, 30% or more?

To be sure, in any given year, the impact of investment costs can seem negligible. But over time, the cumulative damage is devastating. Suppose you rack up a fistful of costs, so that your portfolio gains 7% a year, while the market returns 10%. Doesn't sound too bad? If that performance gap continues for 20 years, your portfolio's growth would be just half that of the market.

Waiting It Out

Investors often comment that "you can't lose money if you hold a bond to maturity." In the next breath, they will often note that bond funds aren't nearly as safe, because you don't know how much you will get back when you sell. But are individual bonds really safer? You guessed it: It's just another financial illusion.

Suppose you bought both a high-quality corporate bond fund and an individual corporate bond with 10 years to maturity. If interest rates then rose, both the fund and the bond would fall in value, which means you could get a disappointingly low price if you have to sell.

But if you are like most folks, you will kick yourself over the fund's loss, but you won't be nearly so upset about the individual bond. Why not? You can comfort yourself with the thought that, as long as you hang onto the bond, you know precisely how much interest you will receive each year and precisely how much you will get back when the bond matures. By contrast, there is no such certainty about the bond fund's return.

But just because you can calculate an individual bond's return to the last penny doesn't mean it is the safer investment. What if the company that issued the bond gets into financial difficulty? You could be in a heap of trouble, because your entire investment is riding on that one company.

Indeed, in that situation, you would be much better off with a bond fund, because you get the true safety that comes from owning a diverse portfolio of bonds.

Result? With the fund, you know your investment will never get wiped out by a single troubled company.

Write to Jonathan Clements at jonathan.clements@wsj.com