Misconceptions are Vultures of Investing
by Ryan W. Smith
Investing is a difficult, often frustrating task, even for the most seasoned of investors. Market forces outside of individual control will often eliminate, in mere hours or days, gains that often took years to achieve. Learning about these market forces, situations that can lead to their arrival, previous market responses to similar situations and even the often-praised “portfolio diversification” can only go so far.
Rather, a consistent approach is necessary to reap true, sustainable long-term gains from investing, fending off market forces outside our control and sailing through any storms encountered. However, there is one aspect of investing that even the most consistent, calm and reasoned investors often fall prey to: misconceptions masquerading as “conventional wisdom” or worse, as fact.
Many times, these misconceptions first squeeze their way into the conversation from confident people who had a lucky streak and aren’t afraid to tell others just how they did it. Similar to gamblers who have rolled hot dice for 20 minutes or pulled a slot machine lever at just the right time, many investors mistake their luck for knowledge, that they know “something” others do not and that their actions can be repeated, by themselves, by others, at any given time regardless of circumstance just by following a few simple tips. Many investors, many gamblers, have lost many dollars following this logical fallacy.
This misconception, the investment version of a game of Telephone, is one of many that can befall anyone not paying enough attention. Here are several other misconceptions that get in the way of true, sustained investment returns:
1) Market Timing
Most investors will claim, upon questioning, that they do not try to time the market. Buy low, sell high is a wonderful thought but in reality, this investment mantra can only work in the long-term. Trying to sell when the market is at its zenith, then buy again at its nadir is a skill that is often not repeatable. For one, the price, market, earnings or industry of the assets in question are most likely different. Even if Stock A and Stock B are direct competitors, with similarly tight trading ranges and investment outcomes over the long-run, they are not the same stock. Just because an investor timed a buy/sell trading strategy for Stock A, doesn’t mean that the same strategy or even a similar one would ever work on Stock B.
In news reports, articles and videos, there is never a lack of people who claim “they knew” something was going to happen and that their method of investing paid off. But how many people actually sold out of their entire portfolios in September 2007, knowing that an epic sell-off was about to occur, then waited on the sideline for 18 months and re-invested in March 2009? Many of the high profile investment “stars” of the 2007-9 Great Recession were one-hit wonders. John Paulson’s famous gamble on gold did not pan out. Even the famous “Dr. Doom,” Nouriel Roubini, who did in fact call the Great Recession correctly has not said much in recent months after saying that the markets were “manic depressive” in January 2016.
There is even data backing up this misconception as a fool’s errand. Morningstar has published information based on an examination of U.S. equity markets from 1995 to 2014. Their study showed that missing the 10 best trading days of the year would reduce returns in an average portfolio from 9.9% to 6.1% for the year, while also showing that missing out on the 20 best trading days of the year would returns to a mere 3.6%. The markets might be a staircase going up and an elevator coming down, but if you are waiting for the elevator, you are likely to miss out on the best parts. My first boss at a trading desk, during the soul-crushing days of the Dot com bust in 2000 and 2001, often said that “Market timing is a suckers bet, but I will gladly take your money if you want to place it on the table.”
2) Index Funds are Always Safest
While it is true that Index Funds have a much lower expense ratio than along with lower fees overall, and it is true that Index Funds in recent years have vastly outperformed the majority of actively managed funds, this is not always the case in all corners of the market. Broad-market Index Funds can spread out risk very well, leading to excellent returns over time. However, investments in smaller Index Funds or Sector Funds can actually be more risky than actively managed funds if market conditions overall take a sudden turn.
Fixed income index funds, for example, have been shown to favor companies and countries that issue the most debt. Abstractly, this is an obviously bad idea. However, few saw it as a major problem in 2010 that many European sovereign debt indexes were heavily invested in bonds from countries like Spain, Italy, Portugal, Ireland and Greece. By 2011, everyone saw that problem.
Other indexes which have shown this very problem were the U.S. High-Yield debt indexes that collapsed along with oil prices in 2011 and 2012 because of their heavy exposure to energy companies with large amounts of debt. Equities too, have had troubles with indexes that were not safe, especially international frontier, or emerging market, indices. Because these indexes measured markets that were more confined, subsections of broader markets, they were not as properly diversified as their active market compatriots and took much more substantial losses when market forces changed.
3) High Yield Stocks Can Be a Bond Substitute
In recent years, as equity markets have soared to new highs, many investors have gone shopping for high-yield equities under the misguided belief that a high dividend stock can replace bonds in a diversified portfolio. It is hard to know for sure why this misconception became so common due to its egregious failing of Finance 101: all equities have substantial downside risk.
For even-keeled long-term investors, noticing a utility stock trading at 17-18 times next year’s earnings in a rising stock market while paying a hefty dividend would be no big deal. For those operating under the guise of this popular misconception, however, they might not notice that the dividend in question might not necessarily be covered by current cash flows. When market forces turn and the company must reduce its dividend, the subsequent yield reduction and stock price fall will often wipe out any short-term gains achieved. Due to their very nature, bonds typically do not have this issue arise.
4) Cash is King
Cash is a terrible long-term investment. Taking into consideration necessary emergency funds and “dry powder” waiting for an opportunity to be used, sitting in cash is not an ideal solution to market jitters. Inflation alone will often eat at portfolio returns like vultures around carrion. For U.S. investors the basic fundamentals of inflation are compounded by the dollar’s use as the international currency of choice, because the dollar is rarely in a weak position, even in stressful times. For anyone with a $1 million in 1977, their cash would only have the rough equivalent of $225,000 in purchasing power 40 years later. Investing, even with a very bumpy ride, is a far better choice for long-term outlooks.
There are many misconceptions that can eat away at portfolio gains. Astute advisors will have built a personal relationship with their clients, hopefully knowing their investors well enough to see what misconceptions might arise to slay their portfolios. Using portfolio analytic tools like AdvisoryWorld’s SCANalytics program can assist advisors in gaming out various scenarios for their clients to illustrate the misconceptions eating away portfolio returns. But in order to slay the turpitude of misconceptions, advisors must not fall prey to them as well.
A proper, diversified portfolio, built to withstand turbulent market conditions, yet able to reap high returns when the wind blows true is something every investor, every advisor aims to build. However, in many cases, avoiding the pitfalls of misconception, looking at the long-term picture and ignoring short-term noise is a victory in and of itself.