Busting Today’s Great Investment Myths

Dec 08, 2015

Reviewed by: Alan Miller

Edited by: Alan Miller

It is the job of marketing departments to come up with new investment terminology, fads and revelations. The problem is that their slick advertising creates and then perpetuates investment myths that have no basis in reality, leading unsuspecting consumers down the wrong investment path. Here is my selection of the worst culprits.

Myth #1 - Index funds always do worse than active funds as they are forced to buy 'bad' stocks

Since index funds invest in the whole market, they must by definition include good, bad and average quality stocks. Similarly, the sum of all the non-index funds holdings must also be exactly in line with the market, and must include those same good, bad and average quality stocks.

Furthermore, the stocks regarded as high quality are normally highly valued and therefore prone to disappoint those investors hoping for a high return. Data from 1997 to 2015 shows that so-called low quality stocks have considerably outperformed high quality stocks.

Source: SCM Direct.com, Bloomberg

Myth #2 - Active managers protect you in a downturn

The spiel is that active fund managers know when the market will crash and can protect their investors by running to cash. However, Professor William F. Sharpe found that whilst indexing guarantees all of the market's losses, active investors, in aggregate, will experience even greater losses when their higher management costs are factored in.

In the US, Lipper studied the six market corrections – i.e. a drop of at least 10% - between August 1978 and October 1990, and found that the average large-cap growth fund lost 17.0% versus the S&P 15.1%.

Standard & Poor's research stated: "The belief that bear markets favour active management is a myth."

In the UK, the results are remarkably similar, with the average UK retail fund having underperforming the market by 2% in 2008.

Myth 3# - Investment committees make better investment decisions

Many advisers and consultants are fixated with the size of investment teams or committees. However, I have always believed that committees are wired to make the worst investment decisions.

The main problem is so-called "groupthink", when members of a cohesive group are more interested in avoiding conflict and maintaining unanimity than realistically appraising the various courses of action. Groupthink can lead to failed analysis of the alternatives, failure to adequately examine risk and failure to set contingency plans. The result is a decision which is often suicidal in investments.

Myth 4# - The 'outcome' of your investment is the most important consideration

Many fund groups say that it's the end result that matters, nothing else. This argument includes costs. My view is that it's not just where you arrived, but how you got there – in terms of both costs and risks. The foremost consideration is balancing cost, risk and returns. Questions should also include: How liquid are the investments? How volatile is the strategy? What is the chance of significant loss? How high are the real costs from start to finish?

Myth 5# - Volatility is the best way to measure risk

The good thing about volatility is that you have a measure to make consistent comparisons between different investments. The bad thing about volatility is that it does not capture much of the true measures of risk – how likely is it that I will lose and how hard will it be to sell, and how long might it take to recover any losses?

Also one can think of many investments that may not change much over a long period of time, then experience a sharp price adjustment e.g. many illiquid stocks or unquoted companies. Are such investments really less risky than others?

Myth 6# - Risk profiling tests can steer investors to make a clear, informed choice

In 2011 the Financial Conduct Authority assessed risk-profiling and asset allocation tools and found that 9 out of 11 of them were flawed.

How many of these tools magically classify users as medium risk and therefore suitable for the equivalent middle portfolio in their range? Are these tools adjusted for the fact that investors answer differently according to their mood, recent headlines, cultural bias and recent events?

I believe these risk tools are about as insightful as horoscope predictions and contain the same amount of common sense.

Myth 7# - Next year will be a stock picker's market

This statement comes down to whether markets or stocks will be correlated the following year or not.

The fact is there are thousands of stocks in every single major market, and there will always be certain stocks that perform brilliantly and some disastrously.

Therefore it must always be possible (normally only with the advantage of hindsight) to pick the best stocks and produce stellar performance. To blame one's performance on it "not being a stock picker's market" is not even worthy of a rebuttal.

Myth 8# - Indexes automatically buy more of something as it gets more expensive

This can be true but there will be many times when the opposite scenario arises. For example, look at Apple. As the graph below shows, the stock's price nearly doubled over a three-year period but because its earnings grew even faster, its valuation based on the price to earnings ratio actually fell: