Convenient truths vs. evidence-based investing
It's easy for investors to absorb myths on best investing practices from the media and financial pundits. That's why it's important to know the difference between well-researched advice and entertainment masquerading as financial news. Be mindful of these eight common investing myths:
Past performance will show you what to expect from future returns.
In a recent research note, "Quantifying the Impact of Chasing Fund Performance," Vanguard compared the returns of a buy-and-hold strategy with a performance-chasing strategy from 2004 to 2013. Across the board, the buy-and-hold strategy yielded significantly higher returns. Unfortunately, investors who relied on past performance ended up chasing returns that the funds did not repeat.
Investment pros are skilled in beating the market.
One peer-reviewed study, "False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas," published in the Journal of Finance in 2009, looked at the 32-year record of 2,076 stock mutual funds. The number of fund managers who beat their benchmarks over time was "statistically indistinguishable from zero," according to the study. The few that beat their benchmarks were simply lucky. Wall Street is extremely proficient in one area: confusing luck with skill.
Investment clubs are a source of sound investment advice.
Investment clubs provide a place for networking and socializing. However, the very nature of the group's activities (stock picking, market timing, trying to select the next "hot" fund manager) will likely result in lower returns. A study, "Too Many Cooks Spoil The Profits: Investment Club Performance," by Brad Barber and Terrance Odean, showed that 60 percent of investment clubs underperform the market.
Alternative investments are good choices.
The hype surrounding these investments is not supported by the data. For the past decade, the index used to measure the performance of the hedge fund industry underperformed indexes in each major stock category and even three Treasury bond indexes. It accomplished this remarkable feat by charging obscene fees, typically 2 percent of assets under management plus 20 percent of profits.
An all-cash strategy is a financially prudent and conservative choice.
An all-cash strategy seems conservative, but it is actually both risky and foolish. It's risky because inflation significantly erodes purchasing power over time. An all-cash portfolio will not keep pace with inflation and practically ensures a loss of purchasing power. This strategy is foolish because the expected return from even a conservative allocation of stocks in a portfolio is likely to at least keep pace with inflation.
All risk is bad.
"Risk" has become a pejorative term. But investors are rewarded for taking risk. Without risk, it would be impossible to achieve inflation-beating returns. There is a reason Treasury bills and certificates of deposit, backed by the full faith and credit of the U.S. government, are referred to as having a risk-free rate of return. Those investments currently pay less than 1 percent.
Warren Buffett can pick stocks. So can I.
Instead of concentrating on Buffett's stock-picking ability, investors would be wise to heed this advice in his recent letter to shareholders: "Forming macro opinions or listening to the macro or market predictions of others is a waste of time." He counsels against listening to "pundits" or -- worse still -- acting on their comments.
If I listen to the best financial pundits, I'll always make the right investment decisions.
Here's an easy-to-implement resolution: Ignore the financial news and the musings of pundits. Their predictions about the future of the market are no more reliable than yours. The best indication of the status of the market is the price set by millions of traders every day. If it became "obvious" to them that the market was about to crash, stock prices would decline.