The world of personal finance is full of axioms and pearls of wisdom. Some have some value, some have limited value, and others are entirely incorrect. Investing myths and various “rules of thumb” can be – at best – limiting beliefs for investors. They can also lead to underperformance and unnecessary losses. In this post we outline where these investing myths and beliefs come from, and why you should be wary of them.
Where do investing myths and half-truths come from?
Investing myths usually start out when someone makes an observation that is accurate. However, it may only be accurate for a specific time period. Or, it may only be true within a certain context, or a certain market. Furthermore, once something is accepted by the market it is likely to be discounted into prices to some degree. As the market changes to accommodate a belief, the axiom is becoming outdated.
The simpler and more compelling investing myths are, the more they spread. Whether they have merit has little to do with how widely they may be believed. The investment industry and financial media also play their part in propagating investment myths, whether intentionally or not.
Top 12 Investing myths and misconceptions
The following are 12 investing myths that may cause you to damage the long term returns of your portfolio.
- You can’t beat the market
- Only the pros have an edge
- The market is a casino
- Blue chip stocks are the best stocks to own
- You should buy stocks with a low PE
- You must buy low and sell high
- Switch to bonds when you retire
- You must avoid volatility and risk
- Active investing is dead
- Gold is the safest investment
- Well-known companies make good investments
- You should switch to defensive stocks if you think the market will crash
1. You can’t beat the market
It is true that most actively managed funds don’t beat their benchmarks. So, if professional fund managers can’t beat the market, how can individual investors beat the market? When you look at the way the mutual fund industry works, it’s not that all that surprising that so many funds underperform. For a start, the success of a mutual fund management business has more to do with distribution than with outperformance. Mutual funds earn fees based on the size of the fund, not the performance of the funds.
With a good sales team, if a fund performs in line with its peers it will be able to attract assets. The biggest danger is underperforming competing funds. Outperforming the market over the long term requires contrarian thinking, which can lead to underperformance in the short term. But this raises the risk of a fund underperforming its peers. It’s just not in the interest of a fund manager to make the types of investments required to outperform the market.
There are other disadvantages to managing large funds too. Buying and selling large positions can move prices and hurt performance. Large funds can only invest for the long term, and they cannot make tactical trades. Many also have limits on the amount of turnover they are allowed. This does limit churn but can also limit a managers ability to be flexible.
2. Only the pros have an edge
One of the most common investing myths is that professional investors have an edge and therefore individual investors cannot compete. It is true that professionals have certain advantages. They have access to better technology and large research teams. They sometimes have corporate access and they can negotiate better commission rates.
However, there are also advantages that individual investors enjoy, and which professional investors don’t. For one, if you have a small account you can enter and exit positions quickly and without affecting prices. If you don’t have clients, you don’t have to deal with inflows and outflows, which means you can plan effectively. Perhaps, most importantly, you can be patient, and wait for the best opportunities.
In addition, trading fees are falling – and in some cases are now zero. The technology available to retain investors is now almost on par with institutional systems, and constantly improving.
3. The market is a casino
From an outsider’s perspective, Wall Street can look like a casino. This is one of the investing myths that is perfectly understandable. In fact, if you treat your investing like gambling, then the market is a casino. However, if you approach investing in a systematic way you can tilt the odds in your favor.
If you use proven investment strategies and manage portfolio risk, you can limit losses and ride winning trades. As an investor, you get to choose how much risk to take, and when you buy and sell investments. With patience and a strategy, the market doesn’t have to be a casino.
4. Blue chip stocks are the best stocks to own
Blue chip stocks are the shares of companies with a good track record, a strong brand and defendable margins. There is nothing wrong with owning a few of these stocks, but you shouldn’t view them as the best route to wealth creation. The problem is that because their earnings are predictable, blue chips are usually fairly priced. They seldom trade below fair value, because as soon as they do, large funds come in to buy them. The result is that while returns are steady, they seldom beat the market.
Blue chip stocks may have impressive track records, but nothing lasts forever. The Dow Jones Industrial Average (DJIA) is considered an index of blue-chip companies. In 2018, just two of the original members of the index, General Electric and Dupont remained in the index. Since then both have been removed. If you only buy blue chips you will never have the chance to invest in stocks like Amazon and Google before their biggest growth phases begin.
5. You should buy stocks with a low PE
Investing myths often gain traction when they appear to offer very simple solutions to the complexity of investing. The PE ratio, or price earnings multiple, is a simple way to compare the values of various shares.
However, there is actually not much of a relationship between PE ratios and future returns. Companies trading on low PEs are very often those that struggle to grow. In fact, a lot of money has been made in the last decade on stocks trading on high PE ratios. When deciding whether a company is cheap enough to be worth buying, likely future growth is as important as the earnings multiple.
6. You must buy low and sell high
Obviously if you can buy low and sell high you should be able to make a profit. But this is not the only way to make money. In fact, it often turns out that buying high and selling higher is more profitable.
Some of the best returns are made when stocks are said to be overvalued, but continue higher, nevertheless. If you are waiting for stocks to get cheaper when this happens, you may end up missing out on significant portion of the bull market. If you are value investing, or plan to buy and hold a stock, then you will be looking to buy low. But momentum and growth investing may require you to buy stocks that are close to their all-time highs.
7. You need to switch to bonds when you retire
Some investing myths simply become outdated with time. One of these is that by the time you retire most of your portfolio should be in bonds. In the past there was some truth to this. However, two things have changed in the last few decades. The first is that interest rates are now, on average, much lower than they used to be. To create a passive income that you can live on with bonds now requires a very large portfolio. If you spend all the income you earn from a bonds portfolio it will never grow as you will lose out on the benefits of compound interest.
The second problem is that people are retiring earlier and living longer. If you retire at 60, you may still need to fund your lifestyle for another 30 to 40 years. To do this, your savings need to continue to grow. So, even in retirement you will need to maintain a diversified portfolio of stocks and bonds, as well as other asset classes.
8. You must avoid volatility and risk
Investing entails risk and it’s understandable for investors to try to avoid risk and volatility. The truth is that investors are rewarded for taking risk. Avoiding risk, by selling your stocks every time you think a bear market may occur, will hurt your returns over the long term. Market timing the entire market is very difficult, and chances are you will sell too early, too often. The result will create a drag on your returns.
The correct way to manage portfolio risk is by using asset allocation to spread risk. Most of your investments will carry a certain amount of risk, but if you diversify across multiple asset classes and within each asset class, losses from one investment can outweigh the other. Diversification allows you to own some risky assets which can generate strong returns, without risking your entire portfolio. Risk should be embraced, but also managed.
9. Active investing is dead
The rise of ETF investing over the last decade or two has created the impression that there is no place for active investing. But this doesn’t mean you should restrict yourself to passive investing or investing in index funds. Stock indices are unlikely to continue rising year after year. When indices get stuck in a trading range, effective stock picking becomes essential.
Investment advisors are under pressure to lower fees, and so it’s understandable that they are recommending ETFs more frequently. ETFs have indeed performed well over the last decade, as a handful of companies have driven high returns for indices. But, if a realignment occurs within the indices, index funds will have a hard time outperforming active funds.
10. Gold is the safest investment
The idea of investing in gold can be very seductive. As safe investments go, gold is the go-to asset. It is widely promoted as an investment using suspicion about central banks. The gold investment thesis is based on the idea that fiat currencies will lose value due to “money printing”. While this may be true, the thesis is flawed. Most people do not invest long term savings in fiat currencies, but in stocks and other assets.
Gold can indeed be a stabilizing element when added to a stock market portfolio. And, while investing in gold may not result in you losing money, it does not offer a reliable return. Gold doesn’t pay interest or dividends and its intrinsic value does not increase.
Cash and bonds can be negatively affected by inflation. But stocks and other asset classes which have historically generated the highest returns can also act as an inflation hedge. Gold should be considered a hedge against a volatility and inflation, but not as a route to wealth creation.
11. Well-known companies make good investments
Market pundits also suggest owning the stocks of companies you like and respect. Warren Buffett has famously said that he doesn’t invest in companies he doesn’t understand. It’s true that he has made a lot of money from companies like Coca Cola and is now an investor in Apple. But most of his investments are in very boring companies like insurers and furniture manufacturers.
Successful investing is about finding stocks, or other assets, that are good investments. Popular companies are often overvalued which makes strong returns very unlikely. They also attract competition, which eventually erodes margins. As quantitative investing research has shown, over the long term it is the stocks that steadily compound earnings that often generate the most reliable long-term returns.
12. You should switch to defensive stocks if you think the market will crash
Every few months analysts and TV pundits begin talking about a stock market crash that is about to occur. Next, analysts begin recommending defensive stocks that can withstand a recession or a bear market. These are companies like consumer staples and utilities which are less sensitive to economic cycles.
Defensive companies are indeed less sensitive to economic downturns. Here’s the problem though; most of the bear markets that are predicted don’t materialize. Investors trying to time the market like this end up buying overpriced defensive stocks and then selling them at a discount.
At the same time, they miss out on appreciation in high beta stocks. The correct way to protect a portfolio from bear markets, or even a black swan event is by spreading risk across asset classes. Investments like hedge funds, private equity, commodities and real estate are not as sensitive to market volatility.
Hedge funds like Catana Capital’s Data Intelligence Fund can use short selling to generate positive returns while market indices fall. Unlisted assets like private equity and real estate have a low correlation with equities precisely because they are illiquid and cannot be sold quickly like stocks can. Portfolio hedges should be in place permanently, and not implemented based on market sentiment or trying to time the market.
Conclusion: Be wary of investment myths
These are just a few of the many investing myths that have become widespread in the world of investing. For the most part you should be wary of any rules that are considered absolute. Successful investing requires prudent risk management and the occasional contrarian bet or calculated risk. There is no holy grail, and investing can seldom be reduced to a simple set of rules.