Fear is a powerful sales tool.

A sales technique that I’ve seen more and more of recently is the exploitation of a person’s political views in order to instill fear and, ultimately, sell undesirable financial products. The pitch goes something like this:

1. [Political event X] just happened or is likely to happen.
2. As a result, the economy will take a nosedive.
3. You should buy my product to protect yourself.

The technique is popular because it’s effective.

The technique is popular because it can be used to appeal to just about any set of political views. (To appeal to people with left-leaning political views, the pitch is typically something to the effect of the market being rigged by the financial elites. To appeal to people with right-leaning views, the pitch is often about over-taxation, over-regulation, or excess government spending.)

And the technique is also popular because it can be used to sell just about anything. For example:

• The economy is going to hell, and that’s why you should buy gold.
• The economy is going to hell, and that’s why you should buy my market-timing newsletter.
• The economy is going to hell, and that’s why you should buy this annuity.
• The economy is going to hell, and that’s why you should invest in my hedge fund.

The fact that this approach can be used to pitch just about anything — as well as the fact that it can be used to appeal to either of two directly contradictory sets of beliefs — is precisely the reason you should never trust it.

In order for the pitch to work out well for you, the pitch-person has to get their political prediction right, they have to get the resulting economic prediction right, and they have to be right (and honest) that the product they’re pitching is indeed a good solution in a scenario in which the economic prediction turns out to be right.

That’s what’s necessary in order for it to work out well for you. In order for it to work out well for them, they just have to convince you to buy in the first place.

A reader writes in, asking:

“I recently learned about ‘Inverse ETFS’ that do the inverse of what the market does: up by 5% if the market is down by 5% and so on. Can these be a useful tool for scaling down risk in a portfolio?”

For most individual investors inverse ETFs are not an ideal method for reducing risk. Frankly, I would encourage most individual investors to stay away from inverse funds, especially leveraged ones.

For those unfamiliar with the concept: An inverse ETF seeks to do exactly the opposite of whatever the index in question does on a given day. For example, ProShares Short S&P500 seeks to provide -1x the S&P 500’s daily return. So if the S&P 500 goes down by 1% in a given day, this ETF should go up by 1%. There are also leveraged inverse ETFs that seek to provide a multiple of the opposite of the index’s daily return. For example, ProShares Ultrashort S&P500 seeks to provide -2x the return of the S&P 500 each day.

The problem with inverse ETFs isn’t that they fail to do their job. In most cases, they do a good job of delivering the targeted return each day. The problem is that, over an extended period of time, the math doesn’t work out the way that most people would intuitively expect.

For example, take a look at the following chart (made using Morningstar’s website). It shows the performance of the Vanguard 500 Index Fund (in blue), ProShares Short S&P500 (in orange), and ProShares UltraShort S&P500 (in green) from 1/1/2008 to 12/31/2009. (You can click the image to see a larger version.)

Over the period in question, the regular S&P 500 index fund lost approximately 20% of its value. Many people would therefore expect the inverse ETF to have increased in value by about 20%. But it didn’t. It only increased in value by about 1.2%. And the leveraged inverse ETF didn’t go up in value by 40%. In fact, it didn’t go up in value at all. It decreased in value — by every bit as much as the regular S&P 500 fund!

Why Do Inverse ETFs Work This Way?

The reason that inverse ETFs provide -1x the index’s return on a day-to-day time frame, yet something very different from -1x the index’s return over a longer time frame is simply math. Let’s look at a simple two-day example.

Imagine that a given index goes down by 3% on one day, then up by 1% the following day. Over this two-day period, the index will have provided a total return of -2.03% (because 1 x 0.97 x 1.01 = 0.9797, which is 1 minus 0.0203).

But an inverse ETF (going up by 3% in the first day, then down by 1% on the second day) doesn’t provide a positive return of 2.03%. It provides a positive return of 1.97%. That’s obviously a small difference. But when you compound such differences over an extended period, the result is that inverse ETFs will often provide a return that is very different from the opposite of the index’s return over that extended period. (And leveraged inverse ETFs will generally provide a return that is much worse than the the index’s return, multiplied by the applicable daily multiplier.)

If you want to make a bet that a particular index is going to decline in value on a particular day, inverse ETFs are a good tool for that purpose. But very few investors should be betting their financial future on such short-term fluctuations. For most people, if you want to reduce the degree to which you are exposed to stock market risk, the best solution is the simplest one: reduce the percentage of your portfolio that is allocated to stocks.

The following questions — and others of a similar nature — are some of the most common in my email inbox:

• Does buying an S&P 500 fund count as stock picking, given that there’s a committee of people choosing which stocks are included in the index?
• Does overweighting U.S. stocks (or value stocks, or REITs, or whatever) count as active investing?
• Does rebalancing count as market timing?
• Does basing my spending rate in retirement on market valuations (and/or interest rates) count as market timing?
• Does Social Security count as a bond?

Typically, the person is asking the question because they’ve latched on to a sound bite-style piece of investing wisdom (e.g., stock picking is bad, market timing is bad, passive investing is better than active investing, your bond allocation should be equal to your age, etc.) and they’re trying to figure out how to apply it.

Sound bites are helpful when you’re first getting started investing, because they allow you to put a decent plan into place without being completely overwhelmed with information. But as you might imagine, they tend to be oversimplifications. And, eventually, rather than trying to base every decision on such simplified advice, you’re better off taking the time to understand the reasoning behind the sound bite, so you can make critical decisions on your own.

For example, why do we often say that stock picking is bad? The answer:

• It results in less-diversified portfolios,
• It often results in higher costs (i.e., brokerage commissions and sometimes taxes) as the investor rapidly buys and sells various stocks, and
• There’s quite a bit of research showing that it’s unlikely that you’ll consistently pick above-average stocks anyway.

Once you understand that, you don’t have to ask whether something counts as stock picking. You can simply determine for yourself whether the activity in question has the same drawbacks — because, ultimately, that’s what you really care about.

So for example, if you’re considering using an S&P 500 index fund in your 401(k), rather than wondering whether or not that would count as stock picking, you can instead try to directly address the important questions:

• Would using that fund allow you to be sufficiently diversified? (And, is there a way to be better diversified?)
• Would using that fund result in high costs? (And, is there a way to achieve lower costs?)
• Is there any reason to think that the stocks included in the index (and therefore the fund) are in some way systematically chosen to be poor performers?

In summary, when it comes to investing, when you find yourself asking, “Does _____ count as _____?” there’s a good chance you’re asking the wrong question.

A reader writes in, asking

“On the Bogleheads forum I see people recommending the ‘three fund portfolio’ with Total Stock Market, Total International Stock, and Total Bond Market funds. But I never see something this basic anywhere else. Elsewhere, I see portfolios recommended that include many more funds or articles recommending the new and improved types of index funds. What’s wrong with a normal index fund portfolio? Why doesn’t the three fund portfolio or anything similar get talked about anywhere else?”

To understand this phenomenon, I think it’s helpful to step back and look at an industry trend: Over the last several years, the idea that passive investing is generally preferable to active investing has become the conventional wisdom. Evidence of this trend is all over the place — the massive size of Vanguard, the explosive growth of assets invested in ETFs, or the steadily-rising percentage of equity mutual fund assets that are invested in index funds.

But that new conventional wisdom presents a challenge for many parties: How do we make money?

Mutual fund companies are unlikely to beat Vanguard at their own game. (And most fund companies wouldn’t even want to — there’s not a lot of money to be made by being the rock-bottom-cost provider of a commodity service.) So they need something to sell you other than your basic market-weighted index fund. But they still want to fall under the “passive” umbrella so that they can get all the marketing benefits of being associated with the passive-beats-active conventional wisdom. So now rather than fund companies pushing their actively managed funds, we see many pushing a new breed of fancy-passive funds: smart beta, equal-weight index funds, fundamental index funds, and so on.

And advisors who practice only portfolio management (rather than broader financial planning) have a similar predicament. Passive portfolio management is already available at a very low cost via all-in-one funds (e.g., Vanguard Target Retirement Funds) or via a “robo-advisor” such as Betterment or Wealthfront. Advisors can’t beat those services on cost, so they have to show that they can do something better. In most cases, that means trying to convince you that the portfolio that they will craft for you is better than the portfolio you’d get via one of those less expensive options. And it’s easier to convince you of that if they recommend something that looks very sophisticated.

Now, to be clear, writers (myself included) are faced with the same dilemma. There isn’t that much to say about a boring market-weighted portfolio made of just a few index funds. And there’s even less to say about a portfolio consisting of nothing but an all-in-one fund. And yet we need topics for articles. So you’ll find us writing about a whole list of other investment strategies.

In other words, at least a part of the reason why simple portfolios using traditional index funds don’t get a great deal of discussion is that, in many cases, it’s more profitable to talk about something else.

A reader writes in, asking:

“After reading your books and others on the Boglehead reading list, I think I’ve determined that my new money should go to Vanguard index funds. But I’m thinking about keeping my existing savings with the advisor I’ve been using for several years. I’m less optimistic than ever about his ability to beat index funds but it seems like leaving him would mean that all the money I’ve paid in commission and fees over the years would be a waste. Does this line of thinking make sense?”

To put it bluntly, no, that line of thinking doesn’t make sense.

In economics, the commissions and fees that you’ve already paid your advisor would be referred to as “sunk costs” (i.e., costs that you’ve already paid and which cannot be recovered regardless of which action you take). For decision making purposes, sunk costs are irrelevant and should be ignored.

This concept is often best explained with an analogy. Imagine that it’s Saturday afternoon, and you just spent $9 to see this summer’s latest blockbuster movie. Twenty minutes into the movie, however, you realize that it’s simply not for you. In fact, it’s terrible. At this point, the $9 ticket price is irrelevant. Sitting through the rest of the movie doesn’t get you your $9 back. All that matters is what you want to do with the next 90 minutes of your life. If sitting through the rest of the movie isn’t the option that brings you the most happiness, you shouldn’t do it.

Commissions and fees that you’ve already paid to an advisor are like that $9 movie ticket. You’re not getting them back. So the only question that matters is which route looks best going forward.

In other words, if there is no cost to make the switch (e.g., capital gains taxes), the only thing that matters is which you expect to perform better in the future: money that you have invested with the advisor, or the Vanguard index fund portfolio that you’ve planned. If you think the index funds would perform better, there’s no sense continuing to pay more fees just because you’ve already paid some fees.

Most insurance products stink.

When you buy a term life insurance policy to protect your young family, there’s a very good chance that you’ll collect absolutely nothing in exchange for your premiums.

And when you buy homeowners insurance, there’s a good chance you’ll get back far less than what you spend on the policy.

And when you buy a fixed lifetime annuity, there’s a decent chance you’ll die well before reaching your life expectancy, thereby resulting in an atrocious return on investment for the money you spent on the premium.

And this stinkiness — the ability to “lose” each of these bets — is precisely what makes these products helpful.

Can’t-Lose Life Insurance

Imagine 1,000 thirty-year-old people buying 15-year term life insurance policies on the same day. Because most of these people will not die before age 45, most of these policies will pay out nothing at all. And this is what allows the insurance company to provide such a large benefit to the beneficiaries of the policyholders who do end up dying.

This concept is known as “risk pooling.” And it is what makes insurance worthwhile.

By way of comparison, imagine if our hypothetical 15-year term policy was instead rewritten so that the benefit amount was paid out to each policy holder a) upon death, or b) at the end of the 15-year term. In such a situation, there would be no risk pooling, because every policy is going to have to pay out. As a result, the benefit amount would obviously have to be dramatically reduced — so dramatically, in fact, that there would typically be no point in buying such a policy.

In other words, if an insurance product doesn’t offer the possibility of a very poor outcome, there’s going to be little or no risk pooling going on, and it will typically not be able to offer much bang for your buck in terms of protection against whatever it is the policy insures against.

When An Insurance Product Promises Everything…

Whenever you encounter an insurance product that promises to pay you money regardless of the situation, it’s time to be skeptical.

For example, equity indexed annuities (sometimes called fixed indexed annuities or hybrid annuities) are often sold on the premise that they:

• Guarantee your capital, thereby protecting you against market declines, while
• Allowing you to participate in market gains.

It sounds like a win/win. But if the insurance company is insuring you against loss, how can they afford to give you the positive returns that result when the market goes up? Where does the money come from?

As it turns out, the answer is that they don’t give you all of the returns from good years in the market. Typically, they leave out dividends, and they limit the return in other ways such as imposing an annual maximum. (In addition, they typically hit you with large surrender charges if you try to get out of the annuity within the first several years.)

Another insurance product that appears to offer a no-lose proposition is the variable annuity with a “guaranteed withdrawal benefit” rider. These products:

• Guarantee a certain (non-inflation-adjusted) level of income for the rest of your life (regardless of how poorly the markets perform), and
• Give you the chance to have that level of income increase if the underlying mutual funds in the annuity perform sufficiently well.

Again, it sounds great. But the reality might not be as good as the sales pitch. The problem is that:

• The guaranteed level of income is significantly lower than what you can get from a simple fixed lifetime annuity, and
• The annual costs charged on the investment are quite high — usually well over 2%, sometimes more than 3%.

As a result, it’s difficult for such products to outperform a simple “buy a fixed annuity and invest the difference” strategy. (Note: Vanguard’s GLWB product does have significantly lower costs than most such products, which makes it a much better deal.)

What’s the Catch?

If you can’t figure out the way in which an insurance product stinks — that is, you cannot figure out a single way in which purchasing the product could result in a bad outcome — that is not actually a good sign. In fact, it should be a red flag. More likely than not, it means your evaluation of the product is off-target in some way.