Warren Buffett often tells people not to focus on day-to-day movements of the stock market; he prefers to take the long view.
ALSO READ: What is a Mutual Fund?
That’s good advice; getting caught up in the daily movements of the stock market is enough to drive anyone crazy. There’s a lot of investing tips floating around out there, but for every good piece of advice there are two or three stinkers.
Have you ever heard someone say “investing in the market is gambling”? You hear this being thrown around when people are trying to dissuade others from getting involved in the market, but it’s just untrue. Gambling is when the money from the losers is used to pay the winners, a zero-sum game. In the world of investing, wealth is being created. You buy stock in a company which then goes on to produce goods that add value to the world – that’s wealth creation, not gambling.
Here are some of the most common myths of the market:
1. Set it and Forget it Investing
Target date funds, also known in the investing business as life cycle funds, are designed to be convenient. Invest your money in a fund, leave it in there for years while others take care of the asset allocation and diversification part, and then profit once you are ready to retire. Easy game, right?
The simplicity of this investing solution is tempting and target date funds are very popular in the U.S. In theory these funds mimic behaviour that you as an investor should be following anyway: invest in equities when young while becoming more conservative as retirement draws nearer.
You are still at the mercy of the market and when you choose to retire can have a big impact on your returns. For example, all 264 target-date funds sold by 39 mutual funds performed poorly after 2008. Even the most conservative – designed to weather any storm – fell on average 17% in 2008.
Additionally, it is unwise to think your portfolio is complete with a simple set-it and forget-it approach. There are other asset classes beyond equities, bonds and cash and being exposed to real estate and commodities are all part of an all-round investing strategy.
2. What Goes Up Must Come Down
Mean reversal, or the school of thought that says prices and valuations in the market tend to fluctuate, is an idea that has been around for a long time.
The graph above shows U.S. and European corporate profits for the last 35 years and we can see them clearly oscillating around a long term level.
Next, let’s take a look at the Dow Jones.
We see that in general stocks tend to march upward over time, but to be specific the stock market consists of a series of upward AND downward moves that result in a net increase over time.
While there is some truth to the concept of mean reversion for parts of the market, (earnings etc.) we aren’t so much concerned with IF mean reversion will happen but WHEN it will happen – and therein lies the problem. Knowing how to time the market is no simple task and requires meticulous analysis.
3. Invest With Me, I Can Pick the Winners
Every fund manager out there is asking for your business, banking on their reputation and ability to turn your endowment into a hefty sum. There are plenty of names out there. Peter Lynch was one of the more well-known stock pickers and he did very well for himself.
If only you could get the secret to Warren Buffet’s approach and you’d be a mega-millionaire right?
No one has ever been shown to be a consistently good stock picker. Yup, not even Warren Buffet. According to Seeking Alpha, Buffet does very well compared to almost every fund manager out there but falls short when compared to a popular market index, the S&P Midcap 400.
That’s right. If you invested in the S&P Midcap 400, you would have outperformed Warren Buffet. In fact, depending on what time period you use, the S&P 500 will generally be ranked halfway amongst all the actively managed funds. That means the S&P 500 outperforms at least HALF of all actively managed funds out there!
You’re better off putting your money in a low-cost index fund that tracks the overall market.
4. Gold is a Good Hedge
Gold bugs will not hesitate to tell you where to put your money. When inflation gets out of hand you’ll thank the savvy investor who told you hold onto your stocks of gold. Unlike currency, gold holds its value. A brick of gold today will preserve its worth from one generation to the next.
It is widely believed that gold is just a good hedge. People often buy gold on anticipation of market and currency drops as gold is expected to rise when the dollar or the stock market falls.
Gold is also known as the crisis commodity, because people tend to buy up the precious metal when geopolitical tensions rise. When threat of coups rise and confidence in governments is low, gold tends to do well.
It was observed that gold fell nearly 1/6th of the time when stocks fell – hardly making it a good hedge. Additionally it was found that changes in gold prices are independent of currency changes – again making it a bad form of protection against another asset class.
The bottom line: gold is not a reliable hedge during periods of stock market turbulence.
What is true is that gold has been a good hedge of inflation over the very long run (100 years+) but not so much in the medium to near-term investing horizon.
In the right allocations gold can be a useful component of any portfolio, but gold does not provide the amazing protection that many people claim it does. Many portfolio constructionists recommend holding less than 3% of your assets in precious metals such as gold and silver.
Those are just a few of the myths in the investing world but there are plenty more out there.
Have you heard of any stock market urban legends? If so, share them in the comments below and we’ll debunk them in part 2!