5 Common Investment Myths

Categories: Invest

mythsDon’t be Fooled by These Common Myths

A myth is something that most people believe, but after careful analysis of the facts, it’s not found to be always true. The investment world has several myths, or things that most people believe as conventional wisdom. 5 of the most common investment myths are:

Myth # 1: Missing the 10 Best Days

The billion dollar mutual fund industry as been reporting for decades that if you are not in the stock market the entire year, and miss the 10 best days, then your portfolio will under-perform the market. This is based on the belief that only a few random days are exceedingly good in the stock market, and you don’t want to miss them. Careful analysis by Paul J. Gire illustrates that this isn’t always true.

Does this mean that I believe in market timing?  Market timing is careful analysis so that someone knows exactly when to get and out of the market. Even in this computer age, and increasing market knowledge every day, no one has ever consistently predicted the investment markets, so I don’t believe in market timing most of time, but see Myth #5 below.

James W. Watkins, III. Of the blog CommonSense InvestSense  in his article Right Right investing  covers this issue wonderfully: “Dynamic portfolio management does not advocate the “all or nothing” approach of classic market timing.  Dynamic portfolio management maintains that while investors should not respond to every twist and turn in the stock market, investors should adopt an appropriate risk management program and react to intermediate and long-term trends in the market in order to prevent large losses.   Combining “effective” diversification with an effective risk management program provides an investor with the best opportunity for consistent returns and the prevention of large, unnecessary investment losses.

Advocates of static asset allocation also point to the potential costs of a dynamic approach to portfolio management, both in terms of the potential loss of portfolio gains and increased taxes from the sale or exchange of portfolio assets.  In terms of the potential loss of portfolio gains, proponents of static asset allocation point to the cost of missing the best days of the market.

Interestingly, such reports usually fail to examine the other side of the issue, the benefits of missing the worst days of the market.  A recent study comparing the costs and benefits of the best days/worst days argument found that the benefits of missing the worst days of the market overwhelmingly exceeded the costs of missing the best days of the market.6 Javier Estrada, “Black Swans, Market Timing and the Dow,” available on the Internet at papers.ssrn.com/sol3/papers.cfm?abstract_id=1086300, 3-7″.

Myth #2 Elephant hunting or waiting for home runs

One warm Saturday afternoon during a long bike ride with my neighbors, one of my companions asked me what I did for a living. After telling him I worked in the financial industry, the first thing he wanted to know was if I knew of a great stock he could buy. He had a friend that bought some stock for less than $2 per share a year ago, but was now up to $28 per share. A lot of people wait on the investment side lines, leaving their money in cash or savings. They want that big stock performer that was going to give them a huge return. However, most people would be better off researching good funds or investment adviser, and get into the market and invest for the long haul. Waiting on the sidelines with money left in savings earning hardly any interest is a bad thing to do. It’s terribly difficult to identify stocks that are going to skyrocket. Most people pick one or two stocks they think will take off, but end up having poor performance. They would probably have been much better off just using asset allocation and intelligent investment decisions, instead of letting greed get the best of them.

Myth #3: Buy investments that have performed the best

When comparing the funds in your 401(k) or trying to pick which mutual funds to buy, many people look at past performance, and pick the one that has performed the best over the past few quarters or a year or two, or since inception. Short term performance can be very misleading, as can ‘since-inception’ return. Mutual funds buy and sell stock at different times, and short-term results can be bad for really good funds. If the fund had a particularly bad quarter, that is a good reason to ask questions, but not to rule it out. Maybe something happened that is not indicative of bad overall management, but it would be good find out results for 1 year, 3 years, 5 years, 10 years, 20 years, and 30 years, and compare it to an investment index that is close to the fund, for the same time period. Comparing it to the fund’s peers is also a good idea. Performance literature often has this comparative peer and index information. Next find out if there was change in firm management, investment adviser, or if there was a particular high turn-over rate (redemptions out of the fund). Ask what challenges the fund or investment firm has had to address in the past, and find out information about the current management. The reason I don’t compare ‘since-inception’ returns is because that depends on when the mutual fund was created. For example, most mutual funds are started, with an initial amount of money and the purchase of its first investment portfolio. If the fund was created during a time when stock prices were very low comparatively, then it could have really great since-inception performance, and much greater than a mutual fund that started business the following year, when stock prices were a lot higher for example.

Myth #4: Index investing is always the way to go, because its hard to beat the S & P 500

You’ve read the articles that declare the Standard and Poor’s Index of 500 stocks outperform 80% of all mutual funds. If this is true, then why not search for investments that consistently do better than the indices? There are over 7,000 funds available to investors today, so that leaves over one thousand funds out there that will do better than the market’s average. Some firms will screen funds and do technical analysis to help you find the best funds. They might charge you a fee to do so, but be careful. If the fee is high, somewhere over 1%, then it would be good to find out what you get for the fee. Do you get financial planning services, tax planning and harvesting assistance? However, if the fee eats up most of the difference between the average and what they provide, you have to ask yourself was it worth it?  It might be, since advisers help control client’s emotions when the market gets skittish and people want to get out of stocks. Also, some managed portfolios might even have less market risk and volatility but achieve equal or superior return. These things are worth it for many people. However, many people find it difficult to locate a great investment professional. If you have one, keep them and treat them well.  Those that have difficulty finding the right match of personality and investment skill, either do fund research themselves, or use low-cost online management services to asset allocate index funds or ETFs.

Myth #5: Timing the market is always bad

Buy and hold is usually the best way to go, and is touted by a large majority of investment advisers. This is because it is extremely difficult to know when to get out, believing the market is ready for a big correction. Likewise, its difficult to know when the market has bottomed out, and its great to get in. However, when I worked for an investment banking firm, the chief investment officer would watch stock prices very closely. He would see if there was over exuberance in stock investing and if a large number of companies were over-valued. On rare occasions, he would harvest gains, at near peak stock prices, on select investments. He would move the dollars to cash, and would wait for some volatility in the stock market or a big drop, to find bargains, and get back in. Doing so, he was able to reduce risk, and later find bargains. Is this a common practice for the average investor? Probably not, but something to keep an unemotional eye on for the few instances that this might be beneficial, for part of one’s portfolio. Again, if someone is going to do this, it must be non-emotional, and only on very rare occasions, with helpful advise from a very good professional money manager. Second opinions never hurt. This might be especially true for people who are close to retirement, if a lot of their money is in stocks. Market timing is bad most of the time, but it’s a myth that it’s always bad.