Today’s Great Investment Myths
Date Published: 3 December 2015
It is the job of marketing departments to come up with new investment terminology, fads, and revelations. The problem is that their slick advertising create and then perpetuate investment myths that have no basis in reality, and often take unsuspecting consumers down the wrong investment path.
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 the same good, bad and average quality stocks.
Furthermore, the stocks regarded as high quality are normally highly valued and therefore prone to disappointment. The reality based on data from 1997 — 2015, is that so called low quality stocks have considerably outperformed high quality stocks.
Myth #2 – Active managers protect you in a downturn
The spiel is that active fund managers will know when the market will crash and protect their investors by running to cash. However, Professor Sharpe found that whilst indexing guarantees all of the market’s losses, active investors, in aggregate, will experience even greater losses when their higher costs are factored in.
In the US, Lipper studied the six market corrections — i.e. a drop of at least 10%, August 1978 – October 1990, and found that the average large-cap growth fund lost 17.0% vs the S&P 15.1%.
Standard & Poor’s found that: “The belief that bear markets favor 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 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 failure to analyse the alternatives, inadequately examine risk, failure to analyse information, and failure to set contingency plans. The result is consensus decision making which is often suicidal in investments.
Myth 4# – It’s all about ‘outcomes’
Many fund groups say it’s the end result that matters, nothing else; including 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 premier 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# – Risk is best measured by volatility
The god think 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 much is it likely 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 not more risky than others?
Myth 6# – Risk profiling tests can steer investors to a clear choice (sorry robot advisers)
In 2011 the FCA assessed risk tools and found that 9 out of 11 risk-profiling and asset allocation tools were flawed.
Moreover, how many people simply take the middle option? How many of these tools magically classify users as medium risk and suitable for the middle portfolio? Are they 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 pickers market
This statement is based on whether or not particular markets or range of stocks will have a close correlation or not next year.
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 have picked the best stocks and produced stellar performance. To blame one’s performance on it not being a stock pickers market or saying that you should buy this particular active fund as next year will be a stock pickers market would appear to suggest an IQ of approximately 0.
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 arises. For example, Apple. As the graph shows, its price and market capitalisation nearly doubled over a three year period but because its earnings grew even faster, its valuation based on the P/E ratio actually became more attractive: