Many seasoned investors can tell the difference between an amateur investor and a professional one, just by talking to them. Here are some common investing statements that you should avoid using, and some helpful alternatives that will not only make you sound more knowledgeable and wise when discussing the markets, but should also help you think more like a professional investor.
Statement No. 1: "My investment in Company X is a sure thing."
Misconception: If a company is hot, you'll definitely see great returns by investing in it.
Explanation: No investment is a sure thing. Any company can hide serious problems from its investors. Many big-name companies - like Enron and WorldCom - experienced sudden falls. Even the most financially sound company with the best management could be struck by an uncontrollable disaster or a major change in the marketplace, such as a new competitor or a change in technology. Furthermore, if you buy a stock when it's hot, it might be overvalued, which makes it harder to get a good return. To protect yourself from disaster, diversify your investments. This is particularly important if you choose to invest in individual stocks instead of, or in addition to, already-diversified mutual funds. To further improve your returns and reduce your risk when investing in individual stocks, learn how to identify companies that may not be glamorous but offer long-term value.
An experienced investor would say: "I'm willing to bet that my investment in Company X will do great, but to be on the safe side, I've only put 5% of my savings in it."
Statement No. 2: "I would never buy stocks now because the market is doing terribly."
Misconception: It's not a good idea to invest in something that is currently declining in price.
Explanation: If the stocks you're purchasing still have stable fundamentals, then their currently low prices are likely only a reflection of short-term investor fear. In this case, look at the stocks you're interested in as if they're on sale. Take advantage of their temporarily lower prices and buy-up. However, do your due diligence first, to find out why a stock's price is driven down. Make sure it is just market doldrums and not a serious problem. Remember that the stock market is cyclical, and just because most people are panic selling doesn't mean you should, too.
An experienced investor would say: "I'm getting great deals on stocks right now, since the market is tanking. I'm going to love myself for this in a few years when things have turned around and stock prices have rebounded."
Statement No. 3: "I just hired a great new broker, and I'm sure to beat the market."
Misconception: Actively managed investments do better than passively managed investments.
Explanation: Actively managed portfolios tend to underperform the market for several reasons. Here are three important ones:
1. Whenever you make a trade, you must pay a commission. Even most online discount brokerage companies charge a fee of at least $5 per trade, and that is with you doing the work yourself. If you've hired an actual broker to do the work for you, your fees will be significantly higher and may also include advisory fees. These fees add up over time, eating into your returns.
2. There is the risk that your broker might mismanage your portfolio. Brokers can pad their own pockets by engaging in excessive trading to increase commissions or choosing investments that aren't appropriate for your goals, just to receive a company incentive or bonus. While this behavior is not ethical, it still happens.
3. The odds are slim that you can find a broker who can actually beat the market consistently if you don't have a few hundred thousand dollars to manage.
Instead of hiring a broker who, because of the way the business is structured, may make decisions that aren't in your best interests, hire a fee-only financial planner. These planners don't make any money off of your investment decisions; they only receive an hourly fee for their expert advice.
An experienced investor would say: "Now that I've hired a fee-only financial planner, my net worth will increase, since I'll have an unbiased professional helping me make sound investment decisions."
Statement No. 4: "My investments are well-diversified because I own a mutual fund that tracks the S&P 500."
Misconception: Investing in many stocks makes you well-diversified.
Explanation: This isn't a bad start - owning shares of 500 stocks is better than owning just a few stocks. However, to have a truly diversified portfolio, you'll want to branch out into other asset classes, like bonds, treasuries, money market funds, international stock mutual funds or exchange traded funds (ETF). Since the S&P 500 stocks are all large-cap stocks, you can diversify even further and potentially boost your overall returns by investing in a small-cap index fund or ETF. Owning a mutual fund that holds several stocks, helps diversify the stock portion of a portfolio, but owning securities in several asset classes helps diversify the complete portfolio.
An experienced investor would say: "I've diversified the stock component of my portfolio by buying an index fund that tracks the S&P 500, but that's just one component of my portfolio."
Statement No. 5: "I made $1,000 in the stock market today."
Misconception: You make money when your investments go up in value and you lose money when they go down.
Explanation: If your gain is only on paper, you have not gained any money. Nothing is set in stone until you actually sell. That's yet another reason why you don't need to worry too much about cyclical declines in the stock market - if you hang onto your investments, there's a very good chance that they'll go up in value. If you are a long-term investor, you'll have plenty of good opportunities over the years to sell at a profit. Better yet, if current tax law remains unchanged, you'll be taxed at a lower rate on the gains from your long-term investments, allowing you to keep more of your profit. Portfolio values fluctuate constantly, but gains and losses are not realized until you act upon the fluctuations.
An experienced investor would say: "The value of my portfolio went up $1,000 today - I guess it was a good day in the market, but it doesn't really affect me, since I'm not selling anytime soon."
The Bottom Line
These misconceptions are so widespread that even your smartest friends and acquaintances are likely to reference at least one of them from time to time. These people may even tell you you're wrong if you try to correct them. Of course, in the end, the most important thing when it comes to your investments isn't looking or sounding smart, but actually being smart. Avoid making the mistakes described in these five verbal blunders and you'll be on the right path to higher returns.