Investment myths debunked

Whether you are a novice or seasoned investor, you will come across many clichés about how to succeed. From diversification to taking on more risk for higher returns, there is a whole host of investment beliefs that it’s good to question

Use your common sense; investing can open up a world of financial opportunities
Use your common sense; investing can open up a world of financial opportunities

If you are wary of the myths below, carry out careful research and use your common sense; investing can open up a world of financial opportunities.

1. Diversification is key to investment success

The dangers of being insufficiently diversified when investing has been written about at great length. Put simply, have all your eggs in one basket and you stand a greater chance of seeing big losses if something goes wrong. But is this belief watertight?

While spreading your risk generally makes a lot of sense, there are caveats.

Firstly, by buying too many different things, you risk having no oversight to ensure that your portfolio does actually have a good balance.

Secondly, by holding too much, you are likely to do insufficient research and could fail to keep abreast of developments in the businesses or funds you have bought.

Back in 1958, legendary US investor Philip Fisher wrote in his book, Common Stocks and Uncommon Profits: “Investors have been so oversold on diversification that fear of having too many eggs in one basket has caused them to put far too little into companies they thoroughly know and far too much in others about which they know nothing at all.”

There is so much received wisdom around investing, but do we need to take it with a pinch of salt? We look at some commonly held investment ideas and ask whether they stand up to scrutiny

2. No one ever went broke taking a profit

There is a patent logic to this statement. Selling investments when they are up guarantees that you make a profit – using this strategy can’t leave you with nothing or worse.

But following this logic too far could lead to bad investment decisions where you sell your best-performing stocks and keep your losers, hoping they will eventually come back up.

Max Ward, manager of the Independent Investment Trust, explains: “As an investor, the hardest lesson to learn is that you will be wrong an awful lot of the time (I reckon the best investors are wrong 40% of the time), so you need to get good at recognising more quickly than others when you are wrong and act accordingly.”

3. The market knows best

When judging the value of a company, many people simply look at the market consensus, as if it is a wise entity whose view should be respected.

But what if other investors are wrong ? Perhaps they are more optimistic or pessimistic than they need to be or their view is affected by other things that are going on.

Legendary investor Warren Buffett questioned this view in his annual letter to Berkshire Hathaway’s shareholders in 1987: “Mr Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom, that you will find useful.

“If he shows up some day in a particularly foolish mood, you are free to either ignore him or to take advantage of him, but it will be disastrous if you fall under his influence. Indeed, if you aren’t certain that you understand and can value your business far better than Mr Market, you don’t belong in the game.”

4. You can anticipate short-term market movements

Many investors have tried to make ‘buy’ and ‘sell’ decisions on financial assets, usually stocks, by attempting to predict future price movements.

This is something many people do almost instinctively when their view of economic matters determines where and how they invest. For example, they might sell their stocks in a house builder, based on the view that there is a housing bubble and it is about to burst, instead of looking at the specific company fundamentals – whether it is well run, generates cash and has a strong balance sheet. Alternatively, they might move out of stocks into cash in the belief a stock market crash is coming.

John Bogle, founder of The Vanguard Group, says: “Timing the market is impossible. Even if you sold stocks just before a decline (a rare occurrence!), where on earth would you ever get the insight that tells you the right time to get back in? One correct decision is tough enough. Two correct decisions are nigh on impossible.”

What has proved a more practicable and very much more successful strategy than market timing is buying good shares or funds cheaply and then holding them for the long term.

As Philip Fisher notes: “Short-term price movements are so inherently tricky to predict that I do not believe it is possible to play the in-and-out game and still make the enormous profits that have accrued again and again to the long-term holder of the right stocks.”

5. For higher returns, you need to take on more risk

Is it always true that taking on more risk leads to higher returns? Over the long term, buying ‘boring’ quality shares or funds can sometimes prove more lucrative.

Terry Smith, fund manager of the top-performing Fundsmith fund, says: “Rather than seeking superior portfolio performance by buying high-risk stocks, investors should seek out ‘boring’ quality companies that have predictable returns and superior fundamental financial performance, and take advantage of their persistent under-valuation relative to those returns to buy and hold them.”

6. Brokers and their price targets must be taken seriously

Investment notes written by analysts can be useful. Their arguments and analysis can help form your own ideas about the prospects for a quoted company.

But their predictions are not always right.

You should treat projected price targets with caution, especially if they are predicated upon complex maths and estimated earnings far into the future.

In 1958, Benjamin Graham, the father of value investing wrote in his classic book, The Intelligent Investor: “The combination of precise formulas with highly precise assumptions can be used to establish or rather to justify practically any value one wished, however high.”
Some analysts may not be impartial, which can affect their views. This is worth considering when deciding to go with their recommendations.

7. Markets are efficient

Many private investors assume that the markets are efficient, and the price of a stock accurately reflects its value or intrinsic worth. But there can be factors at play that distort the price of different shares.

Fund Manager Neil Woodford explains: “The best financial lesson I learnt was to question the notion that markets are efficient. Economics is the study of human behaviour as much as anything else, and I’m not sure this can be explained in the same way that you can describe how ice crystals are formed.

“I believe the best way to add value is to focus on fundamentals (by which I mean the real performance of a business and the real activity in the economy) and focus on value, not price. In the short term, the market can be profoundly inefficient and obsessed with things that have very little relevance to the long-term success of a company or an economy.”

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