Investing Myths That Need To Go

By Stephen D. Simpson, CFA | September 15, 2010 AAA
Investing Myths That Need To Go

It is almost impossible to make good decisions using out-of-date information. Imagine trying to drive around a fast-growing city like Las Vegas with a map that was printed in 1980. Similarly, investors should be very careful about relying upon old sayings about the stock market - sayings that are so old that they have transitioned from helpful advice to potentially harmful myth. (Learn how to stop using emotion and bad habits to make your stock picks. Check out How To Avoid Common Investing Problems.)

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You Cannot Beat the Market
Academics have spent a lot of time trying to convince people that it is not possible to beat the market. Fortunately for investors, the models that support those analyses are simplified versions of reality with real flaws. In actual practice, people can and do regularly beat the market. It is not easy, and nobody beats the market every year, but it does happen and there are ample studies that show that following simple value-oriented strategies can lead to consistent market-beating returns.

Of course, it is also worth considering whether "beating the market" is even a relevant goal - an investor needs to generate the balance of risk and returns that are appropriate for his or her own goals, and that may have nothing at all to do with the broader market.

Some Sectors Do Well No Matter What the Economy Does
This latest recession has put to pasture the idea that there are a few sectors that can hold up through any sort of economic trouble. Health care has struggled as hospitals saw their capital funds smashed by the credit crisis and fewer patients visited the doctor because they could not afford the co-payments or lost insurance entirely.

Elsewhere, food companies found themselves caught between higher input costs (commodities, packaging, etc.) and sticky prices - forcing them in some cases to surreptitiously shrink packaging to eke out more profits. Even utilities struggled as they found fewer buyers for their debt and less demand as business activity slowed down.

The Stock Market Earns 10%
One of the popular go-to statements about the stock market is that equities produce, on average, about a 10% annual return. Well, yes and no. Looking back to 1871, the market has indeed produced an average return of about 10.6%, but the compounded annual growth rate is more like 8.9%. Moreover, the standard deviation over that period is 18.9, which means the returns in any one year can be significantly different than 10% and still be within the range of "normal".

Investors should also remember that the historical rate of return stretches back over a time when the country and economy were smaller. As the economy gets bigger and the deficits gets larger, it will make future growth more difficult - and that is to say nothing of the impact of millions of boomers withdrawing savings over the coming years. That is not to say that technological innovation will not continue to boost the growth rate, but the idea that market always produces 10% returns is a myth.

"It's Different This Time"
How many times have analysts, investors and commentators tried to wave away ridiculous valuations and unsustainable fundamentals with the pithy "it's different this time"? It was "different" in the late 1990s when tech companies sported ridiculous valuations and the internet was supposedly going to completely revolutionize commerce. It was "different" every time the biotech industry had a new approach to disease (antisense, monoclonal antibodies, gene therapy, stem cells, etc) that was going to produce multi-billion dollar cures. And it was "different" when houses changed hands at ridiculous prices and people could secure mortgages with little more than a nudge and a wink.

Unfortunately, it is almost never different. At the end of the day, things simply do not change overnight and details like fundamentals and value really do matter.

Wall Street is Smart
For all of the training and tools available to Wall Street, individual investors might be surprised at just how ridiculous professional money management can be at times. There are asset managers out there that absolutely will not invest in a stock if the revenue growth rate is less than 25%; a fantastic company with 24% revenue growth will not make the cut. In other cases, the analysis performed by these professionals is so superficial as to be pointless - "semiconductors are hot, so let's buy semiconductor stocks".

The truth of the matter is that Wall Street is focused on the short term and makes decisions that only seem smart when viewed in the short term. Real money is made in the markets by identifying quality companies with strong management and sticking with them through the years. In comparison, Wall Street is obsessed with a beat-and-raise short-term outlook that has them constantly cycling through ideas and looking for the next big thing.

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"X" Will Protect You from Losses
Recognizing the risks that are inherent to stock market, plenty of commentators have their own recipes for protecting portfolios from loss. Diversification is indeed wise, and the judicious addition of bonds, real estate, and hard assets to a portfolio can smooth out the volatility. The myth, though, is that an investor "must" own gold or that real estate is the only real option for smart investors. Alternatives to stocks are just like stocks themselves in one important way - buying the right asset at the wrong price is no help at all and buying overpriced alternative assets is no shield at all.

The Bottom Line
Simple guidelines stick around so long because they are simple - everybody has a certain craving for easily-digested and understood advice. Unfortunately, simple can come at the cost of true, and many of the long-repeated myths about the market just are not true anymore (if they ever were). Investors would do well, then, to keep their eyes wide open and take every investing adage with a healthy dose of skepticism.

For the latest news, see Water Cooler Finance: Mergers, Hostile Bids And SEC Probes.

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