These 10 biggest investing myths play on the hopes and fears of investors and can cost you big money over the long-run
Investing is hard.
No, wait. Investing is easy.
If investing were easy, why did the average investor book annual returns of just 2.6% on a stock and bond portfolio over the decade to 2013? Because the average investor constantly fights their better judgement and submits to investing myths widely held as conventional ‘wisdom’.
Use a rational and disciplined investment strategy rather than falling for the 10 investing myths below and you’ll find that meeting your long-term goals is actually pretty easy.
Investing Myth #1: Follow stock market analysts and those appearing in the financial press to spot investment winners
Investors tune in religiously to their favorite stock-picking show or follow tips by “noted” analysts on the internet. The idea is that these experts have spent their lives combing through financial reports and know how to pick winners.
There are two problems with this myth. First, understand that analysts on TV may have different reasons for pitching a recommendation. The financial press, TV and internet, is a business and must constantly entertain its audience with new ideas. This means countless recommendations every day, even if some of them are a little far-fetched. Ask yourself, are you watching the show for the recommendation or to watch some guy lean on a button that makes funny noises.
The investment advice you see on TV and many websites is not there to make you money but to entertain and is probably not appropriate to your needs. We previously covered how to create a personal investment plan and how to determine which investments were right for your risk tolerance and return needs. It’s ok to get basic ideas from the ‘analysts’ on TV but wait a week before making any investment decisions. Do your own research to make sure the stock is appropriate for your portfolio and the decision isn’t just on a short-term hunch by the analyst.
Investing Myth #2: My 401(k) and other retirement investments are safe because they are in mutual funds
Just because your money is in an account marked for retirement and invested in mutual funds doesn’t mean it’s safe from market turmoil. If the mutual fund is focused on stocks, it is still prone to huge losses when the market crashes. One in five people have 80% or more of their retirement money in stocks, whether individual stocks or mutual funds holding stocks.
Avoiding this myth means understanding what a retirement account is for, safety of income in retirement. This means taking a little less risk in your retirement investments. Even if you still have a couple of decades to retirement and most of your non-retirement investments in stocks, weight your retirement account a little more heavily to bonds and other assets. The return may not be as high but the account will serve its purpose, peace of mind in retirement.
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Investing Myth #3: Picking funds that have done well means they should do well in the future
Past performance is displayed prominently and used as a major selling point for managers. Show people that your mutual fund has ‘beaten the market’ over the last few years and they’ll believe you can do it again. Investors are persuaded to sell out of their current investments to free up cash to invest in these high-flyers.
It’s becoming an even bigger problem lately because of the market’s rebound over the last six years. Investors are shown stellar returns over the last one-, three- and five-year periods and think that performance implies superb fund management. They invest heavily into the fund without looking at expenses charged or if the fund is appropriate in their portfolio.
Research by Vanguard in 2014 showed that investors chasing gains in funds underperformed a simple buy-and-hold strategy by as much as 4% annually over the ten years through 2013. Not only did the buy-and-hold strategy outperform but it was also less risky than the strategy of chasing fund performance.
Spend any time in the financial markets and you’ll get tired of hearing, “Past performance is not necessarily indicative of future results.” It’s a required legal disclaimer that is on nearly all investment material and is painfully true for any fund manager. As an investor, understand that periods of below-average performance is inevitable for any fund. Resist the temptation to sell out of your ‘losers’ and chase past performance in other funds. Make a calculated decision when you make the initial investment and stick with it.
Investing Myth #4: U.S. companies are all the international exposure I need
The average American investor holds more than 75% of their portfolio in stocks of U.S.-based companies. This is despite the fact that the U.S. economy ($17.4 trillion) accounts for just over a fifth of the $77.3 trillion global economy.
The usual response I get to this is that American companies book sales overseas and provide all the international exposure an investor needs. Foreign sales at S&P 500 companies are just 33% of their total sales.
Investing for your financial future is no time to be bound by patriotism. The U.S. economy is expected to grow by just 3% in 2015, under the 3.5% growth rate of the global economy. Emerging markets have fallen out of favor lately but are still expected to grow by more than 5% this year.
You need diversified exposure to companies based in other countries. This diversification will lower your risk because of the difference in economic cycles across the globe. As the U.S. economy slows into its next recession, and it will come, your stocks in foreign companies will do well and protect your wealth.
I won’t say you need to weight your portfolio on the global economy, with nearly 80% in stocks of foreign companies, but you should have at least 30% of your portfolio in foreign assets. The easiest way to do this is just to pick a few funds that invest broadly in foreign investments like real estate, stocks or bonds. These funds will have access to investments that may not be available to local U.S.-based investors.
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Investing Myth #5: My investment club helps to find great buys and keeps me from big mistakes
I love the idea of investment clubs. Unfortunately, they suffer from all the shortcomings of group dynamics. You might think there would be strength in numbers. Bouncing ideas off of each other in the club and talking about investments should lead to the most rational decision, right?
A study by Barber and Odean of the University of California titled, “Too Many Cooks Spoil the Profits,” found that 60% of investment clubs underperform the markets. The average of 166 investment clubs underperformed the market by 3.8% annually and even underperformed the average individual investor’s return.
Higher trading costs accounted for a third of the clubs’ underperformance. Investment clubs pick more investments than individuals, putting less funds in each pick. This means more trading and higher fees. Investment clubs may also invest more heavily in large stocks and growth stocks, the kind you hear about most frequently on TV. This may underperform a more balanced portfolio and is likely to be more volatile than a diversified mix.
Investment clubs are fine and its fun to make investing social. Just remember your own risk tolerance and return requirements and only ‘pick’ stocks with a small percentage of your portfolio. Take the risk tolerance quiz and find your own level of comfortable risk. You do not need more than 20 to 30 stocks for a diversified portfolio and maybe even fewer if you hold funds to provide broad exposure.
Investing Myth #6: You have to have commodities in your portfolio for diversification
This investing myth became very popular over the decade leading up to 2008 and was seemingly confirmed in the rebound after 2009. Of course, it’s easy to believe an investing myth when prices are surging.
The idea is that commodities like metals and oil provide a hedge against risk and inflation. Since these are hard assets, their value should rise as the purchasing power of the dollar falls. As other financial assets like stocks start looking shaky, investors run for safety in these assets to protect their wealth.
There are a couple of problems with holding commodities in your portfolio, either through direct ownership or through funds that hold the assets. First, these assets are just as prone to market bubbles as any other asset. The price of gold soared almost 400% over the six years to 2011 as investors poured into the asset, only to crash 42% in the four years since. This flies in the face of the investing myth that commodities are a source of safety for investors.
The other problem with investment in commodities is that the assets do not provide any return until they are sold, hopefully at a higher price. Vanguard found that an investment in commodities over the 26 years to 2009 would have provided an annual return of just 2.1%, just about the rate of inflation.
Instead of holding positions in commodities themselves, buy shares of the companies that produce those commodities through mining and agriculture. The companies will still provide a hedge against inflation as their sales increase on higher commodity prices and you will earn a dividend yield while you hold the shares.
Investing Myth #7: Investing is basically gambling, so you might as well go for the jackpot!
I hate this investing myth. There are some similarities between investing and gambling. Both hold the allure of striking it rich and involve some risk taking. Because of those similarities, investors rationalize horrible investment decisions on the premise that it’s all a gamble anyway.
Instead of decisions based on their personal investment needs, they go for the big win in penny stocks and hot sectors of the market.
And the result shows up in average investor returns. Jumping in and out of their ‘bets’, investors book returns well under those posted for the market. Over the ten years to 2013, individual investors underperformed the market by 3.4% compared to a market return on a stock-bond portfolio.
Investing is not gambling. In Vegas, the mathematical odds are against you. Investing is about owning a part of a business and benefiting from future profits. Most investors do not need the kind of high-flying returns promised on penny stocks and other high-risk investments. Base your investments on the annual return you need, found in your personal investment plan. Putting together a formal plan, many investors are surprised that they need only modest returns to meet their long-term financial goals.
Investing Myth #8: There is a reason Warren Buffett is called the, “Oracle of Omaha”
If anyone is known as the King of stock investing, it’s Warren Buffett. His Berkshire Hathaway holding company has seen its stock soar 304% over the last 15 years, more than six-times the return on the S&P 500.
So why not just buy what Warren buys?
Articles with his name in the title are always highly read and his annual shareholder meeting is called the, “Woodstock for Capitalists.” But there are several reasons why you shouldn’t follow Buffett blindly into his investments.
Buffett has used massive scale to get the kind of deals you never could. He negotiated preferential deals and guaranteed interest rates for billions in bailout money to the banks during the financial crisis. He also uses a nearly infinite holding period for stocks that isn’t realistic for most investors. Never selling your stocks is fine for a billionaire that enjoys hundreds of millions in cash flow from dividends. Most of us face the reality of having to sell our stocks to reduce portfolio risk as we age or to pay for expenses in retirement.
Even Buffett’s mistakes have benefited from super long investment holding periods. His investment in Coca Cola, starting in 1988, paid off handsomely for decades but has returned just 15% over the last three years. His investment in IBM has plunged by nearly 14% during that time. Both are well off the total return of 63% on the S&P 500 over the same period.
There are some strong companies in Warren Buffett’s portfolio of stocks but you still need to do your own research before blindly jumping into an investment. What might have been a good buy when Buffett invested may be overvalued now and offer little upside potential. Buffett’s 1988 investment in Coca Cola may not be the same as your investment in 2015. Besides checking that an investment is right based on its upside potential, make sure that it fits with the rest of your portfolio. Buffett traditionally invests in very mature companies that spin off cash but may not grow as quickly. An investing strategy mirroring this may put you dangerously overweight in utilities and consumer goods without diversifying exposure to other sectors.
Investing Myth #9: I should have all my money in safe bonds after I retire
This investing myth plays on the fear of market crashes during retirement and there is a bit of truth in it. The idea is that bonds offer a guaranteed return if held to maturity, an important factor for anyone expecting to pay living expenses from their investments.
It is true that you should shift your investments to less risky bonds and real estate as you get older. As you approach retirement, you’ll have less time to see stocks rebound after a major sell-off so protection becomes the overriding theme. Learn more about bonds and their role for stable income in your portfolio.
Holding all your wealth in bonds is taking it to the extreme and could mean running out of money when you need it most.
Since bonds provide a fixed return through interest and a principal payment at maturity, they offer no protection from inflation. Even today’s low inflation of under 2% will cause your purchasing power to fall by a third over 20 years. You can either plan on buying a third less stuff or you can get some inflation protection in stocks. Stocks provide good inflation protection because companies can generally raise their prices along with general inflation.
Besides the risk of inflation, putting all your eggs in the bond investment basket exposes you to interest rate problems. If interest rates fall when you have to reinvest money from maturing bonds, you might not get a yield high enough to pay your bills. Rising interest rates will cause the value of your bonds to decline, a problem if you need to sell investments before they mature.
You probably won’t need more than 10% of your portfolio in stocks after you’ve retired but you do need to keep some exposure. Holding a small percentage of your portfolio in stocks will help protect against inflation and interest rates while still providing the stability of bonds.
Investing Myth #10: IPOs allow regular investors to get in on the ground floor
Investors love to talk about initial public offers (IPOs). Regular investors feel shut out of the game by large institutional firms and big money players. Getting shares of a company just as it is coming to the market makes investors feel like they are getting in on an opportunity.
The problem with this investing myth is that the opportunity has long since gone. Before shares of an IPO are traded in the stock market, the market machine has hyped the perceived value as much as possible. Investment banks that promise to take a portion of the shares go on ‘road shows’ to sell shares and drum up enthusiasm months before the IPO. Hype is built in the market for one purpose, so early venture investors and owners can make billions on day one.
For investors jumping in on the first day of trading, the returns are less than stellar. University of Florida professor Jay Ritter found that IPOs underperformed similar size companies by 3.3% over the five years after their issue on the market.
The solution, avoid the hype around IPOs. If you really like the company and its long-term business strategy, wait for six months to see how the share price and company financials develop. This is usually enough time for the hype to come out of the shares and for investors to start pricing the investment on its fundamental value.
Your turn. What are the biggest investing myths you’ve seen or that have cost you money?