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Investment Myths

Investment Myths

| June 05, 2015

May is an exciting time of the year for my family as among other things it means spring runoff and early season whitewater trips! This year we were invited on a 4-day Gates of Lodore trip launching on May 28th and we jumped at the chance. We enjoy introducing our whitewater passion to friends and this year our kids invited classmates who had never been on a multi-day whitewater trip.

New boaters (and their parents) bring certain perceptions and beliefs about what a river trip is going to be like. In general they overemphasize dangers and discomforts and underappreciate the amazing natural beauty, hikes, gourmet food, teamwork and wonderful community that happens on these trips. Hollywood's depiction of whitewater trips (The River Wild) only reinforces these misperceptions.

There are similar misconceptions in the world of investing where investors overemphasize the impact of certain activities and ignore other practices which may have the greatest influence on their long-term success. I believe the financial press is at least partially responsible. The press needs to create an endless stream of novel content to sell advertising and subscriptions - often frightening headlines and prognostications rather than sound financial advice.

Here are two of the more common investment myths:

Success in investing is all about picking the right stocks and trading them correctly according to your expectations of the markets: The three elements of investing that account for returns are stock selection, market timing, and asset allocation (ie which asset classes to be invested in and in what proportions). I have personally spent tremendous time and energy pursuing stock picking, trading and making predictions about the overall market because I concluded since this is what I was continually reading about it must be important. Like most investors I wanted to understand and, better yet, control how future events would affect my portfolio and participate in the gains but avoid the losses.

I am a huge fan of learning from people who are already successful at something I am interested in by reading their works or personally asking them for advice. My entire worldview on investing changed when I read David Swensen's seminal work "Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment". Swenson manages the $24 billion Yale University Endowment Fund and in his book he observes that stock selection and market timing are both zero sum gain activities since for every party that gains there will be a party on the other end of that trade that equally loses. And considering the transaction costs associated with both these activities the AVERAGE participant actually loses. So if stock selection and market timing are both losing activities then by definition investors make ALL of their positive returns through their asset allocation. And yet you will struggle to find press coverage about this critical topic – I believe because it does not make for interesting copy that sells advertising and subscriptions.

The best way to select mutual funds for your portfolio is to pick the ones that have done well in the past: We have all read the standard disclaimer "past performance is not a guarantee of future results". Despite that, we universally start our analysis by looking at the funds' past returns or "star" rating where the top 10% performing funds receive 5 stars. The biggest problem with this intuitive approach is that the data just does not support the premise that funds that have done well in the past will generally continue to do so. The Wall Street Journal's Sept 14, 2014 article "Mutual Funds' 5-Star Curse" indicated that of the 403 mutual funds receiving a 5-star rating in 2004, only 58 or 14% retained 5-stars 10 years later.

It is common to use the investment terms risk and volatility interchangeably but I believe they are very different. Volatility is the tendency of securities, mutual funds, and ETFs to fluctuate in price and is a consequence of the emotional crowd collectively overreacting to information rather than changes in underlying economic fundamentals at the market and individual stock levels. Risk is the chance of not meeting your financial goals and possibly running out of money in retirement due to investment underperformance. Underperformance is often due to investing in the wrong asset classes and/or behavioral factors such as buying high and selling low.

Last month we pointed out that the average equity investor's portfolio grew at 5.19% per year from 1994 to 2014 as compared to the S&P500 which grew at 9.85% per year. That is the difference between having a $100k IRA grow in 20 years to $655k or only $275k – a very material impact. Investors sacrifice long-term growth when they focus on minimizing the short-term noise (volatility) which is unnecessary if your portfolio is properly structured.

Last month we discussed segregating portfolios by time horizon and this is one of the keys to structuring portfolios for optimal long-term growth. This is a valuable area we help our clients with and we can show you how it works during both your financial accumulation phase and also during retirement when your portfolio will be creating reliable monthly income payments for you. Please call or email us to learn more.

The Standard & Poor's 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. Indices are unmanaged and cannot be invested into directly.