One of my friends in school was renowned for frequently telling us: “I aced that test!” He was never shy about sharing his answers after a test. His certainty about the answers made me question whether my answers were correct.
I eventually realized that he was wrong more often than right, and he became notorious for misplaced self-confidence. When he joined an investment firm after graduating from school, some of us joked about starting a “contrarian” fund to bet against his stock picks. Overconfidence is one of the “deadly sins” highlighted in studies of behavioral economics.
The investment industry is filled with confident people similar to my friend, who may be well-meaning but who also pass along bad ideas that become accepted as conventional wisdom.
Here’s my top five list of misconceptions that become deadly sins of investing:
Misconception 1: “I can get out of the market before it goes down, then get back in for the rebound.”
Why It’s Misconceived: Jack Bogle, founder of Vanguard, once said: “I don’t know anyone who’s got it right. In fact, I don’t know anyone who knows anyone who’s ever got it right.”
Market timing is moving into or out of the market, or switching between asset classes or sectors based on fundamental or technical signals. Most investors claim that they don’t try to time the market, but their behavior belies their claim. Substantial dollars are invested in strategies that promise to rotate among asset classes and sectors, or to provide downside protection in the event of another market meltdown.
The appeal of timing the market is undeniable. If I had a time machine, I certainly would have sold out of the stock market in September 2007 and bought back in in March 2009. However, “all in/all out” strategies aren’t sustainable. Many of the highest-profile winners during the global financial crisis have been one-hit wonders that haven’t enjoyed a successful second act. John Paulson’s bet on gold soured, Meredith Whitney’s call for the demise of municipal bonds was spectacularly off-target and Nouriel Roubini has been quiet since labeling markets as “manic depressive” in January.
Morningstar published interesting findings that address market timing considerations. Looking at U.S. equity market performance from 1995 to 2014, the Morningstar study illustrated how missing the 10 best days of performance would reduce returns from 9.9% per year to 6.1%; missing the 20 best days of performance would reduce returns to 3.6%.
Conclusion: Market timing, however tempting, isn’t a strategy for sustainable success.
Misconception 2: “Top performing mutual funds will continue to be top performers.”
Why It’s Misconceived: Chasing performance is among the most damaging investment behaviors.
The search term “top-performing mutual funds” generates 104 million hits! Studies by Morningstar, Dalbar and Jack Bogle identify significant shortfalls between investor-level and fund performance. Other studies have indicated that in most asset classes, the top-performing funds in one period tend not to repeat as winners in subsequent periods.
Investors may say that they don’t chase performance, but substantial evidence points to performance chasing among individual and institutional investors.
Historical performance is part of a mosaic that includes both quantitative and judgmental elements. Ultimately, we try to answer a specific set of questions:
- What is the fund’s “edge”? Does the portfolio manager or investment strategy have a competitive advantage relative to other investors and the index?
- Is the edge sustainable? Can that “edge” be sustained or will it be eroded by competition or a changing world?
- How will the fund perform in different investment environments? No product does well in every environment. Understanding patterns of performance is critical to identifying when it will rise or fall.
A U.S. small cap value fund that we own has lagged its index year to date. Some investors would consider this fund a candidate for the scrap heap, given its underperformance. We have a different perspective, given in-depth research into the investment philosophy, process and people managing the fund as well as insight from more than two decades of fund performance.
The fund doesn’t invest in REITs, considering real estate to be a distinct and separate asset class. The fund also doesn’t invest in regulated utilities, for different but equally legitimate reasons. We invested in the fund knowing that we had meaningful REIT and regulated utilities exposure elsewhere in our portfolio, so the exclusion of those two segments of the market was not a concern. Taking the exclusion of REITs and utilities into consideration, the fund is performing within our expectations and delivering as promised.
Conclusion: Investors should have an educated point of view about future performance, and shouldn’t consider past performance a promise of future success.
Misconception 3: “Index funds are safer than actively managed funds.”
Why It’s Misconceived: Index funds may be riskier than actively managed funds in certain parts of the market.
Index and “smart beta” products (a term I don’t like) are the cool kids on the block today. TFC Financial invests in low-cost index funds and in funds built around measures related to size, style or profitability factors that have provided long-term return premiums over the market. Despite our embrace of index and smart beta products, we think that it is a mistake to exclusively focus on index or smart beta investments.
For some investment categories, we favor actively managed products for risk management reasons. Some fixed income indexes have inherent flaws, “rewarding” companies and countries that issue the most debt. European sovereign debt indexes are an example, as in 2010 widely used indexes had substantial exposure to Spain, Italy, Ireland, Portugal and Greece.
The indexes were focused on all the places you didn’t when the European sovereign debt crisis began! The same type of scenario played out when oil prices collapsed, as U.S. high-yield debt indexes had substantial exposure to energy companies. In our view, active managers assessing creditworthiness of countries and companies are better positioned to manage risk than bond indexes that are blind to bubbles of credit issuance.
Equities are not immune from problems in index construction. As an example, the most widely used frontier markets indexes are concentrated in a few countries and sectors. Actively managed frontier markets funds are considerably more diversified, lowering risk from our perspective.
The Conclusion: Investors should understand the investment opportunity they’re trying to access, and determine whether an index or active investment alternative provides the best combination of risk and return.
Misconception 4: “High-yielding stocks are a bond substitute.”
Why It’s Misconceived: Dividend-paying stocks are equities and have considerable downside risk.
The low interest rate environment has created an insatiable demand for yield from income-starved investors. Dividend plays have been big winners in 2016, with the high-yielding utilities sector leading the pack.
Utilities stocks trade at an eyebrow-raising 18 times next year’s earnings, a high price-to-earnings ratio relative to the market and to the sector historically. Utilities are a slow-growth, highly regulated sector potentially threatened by the growth of renewable energy sources and energy conservation. The dividend payout that is so valued by investors is not, in many cases, covered by current cash flows.
Many analysts would argue that utilities are in bubble territory and have considerable downside risk. Although utilities have historically been thought of as low volatility investments, there is considerable vulnerability given their high earnings multiples, slow growth, high debt and constrained free cash flow.
Conclusion: Dividend-paying stocks are an appealing part of the market, but have downside risk and shouldn’t be considered a bond substitute. Given their lofty valuations, the downside risk for these “safe” stocks may be greater than the risk of the cyclical stocks out of favor in the market today.
Misconception 5: “I’m safe because I’m sitting in cash.”
Why It’s Misconceived: Cash is risky in lost purchasing power and opportunity cost terms.
Many investors have been hiding out in cash, an understandable reaction to two violent stock market slumps since 2000. I believe in having an emergency fund of three to six months on hand, and of increasing cash or short-term investments as people near retirement.
But cash is a lousy investment. Cash is risky in purchasing power terms, potentially diminishing a retirement portfolio given the insidious impact of inflation. Having $1 million in cash in 1976 is now worth $236,000 in current purchasing power. Even at today’s low rates of inflation, hiding out in cash may be a risky proposition.
The Conclusion: Equities, despite a bumpy ride, historically have provided a far superior return to cash.
Don’t be like my unfortunate friend from school. Conventional wisdom is often wrong, and behavioral tendencies may steer you astray. Keep the following lessons in mind:
- Market timing, however tempting, isn’t a strategy for sustainable success.
- Past performance isn’t a promise of future success, so it’s critical to develop a well-informed opinion about future prospects for an investment.
- Index investments are often a desirable low-cost solution. Understand the tradeoffs between index and actively managed alternatives.
- Dividend-paying stocks are equities and can decline in value! Don’t be complacent about the risks when searching for yield.
- Equities, despite a bumpy ride, historically have provided a far superior return to cash.
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