Myths and misconceptions

Aphorisms litter the investing lexicon, offering a potentially seductive short cut to success.

Aphorisms litter the investing lexicon, offering a potentially seductive short cut to success.

But do they stand up to scrutiny? Let's look at six of the most popular.

1. Sell in May and go away

This assumes that, each year, the market peaks in May and subsequently declines. Is this true?

It may have been but isn't now. The market features millions of forward-thinking, competitive and, above all, adaptive investors.

If I knew the market would peak in May, I would sell into the rally, as would everyone else when they cottoned on to the same fact. The market would then anticipate the "May peak" and peak in April. When people figured this out, another change would occur.

Eventually, all well-known, profitable patterns - if they exist at all - must cease as investors take advantage of them. This adage endures because of rhyme, not reason. BUSTED.

2. It's time in the market, not timing the market

"I'm not against making money in the short term," a US value investor, Tom Gayner, says. "I just don't know how to do it."

In a perfect world you would be able to make quick, large profits and then recycle them into the next cheap stock. But cheap stocks face problems - that's usually why they're cheap - and take years to resolve. That's why "time in the market" is important.

But this aphorism misses the importance of valuation.

Over the past 10 years, the stock price of US listed discount retailer Wal-Mart remains largely unchanged, despite more than tripling earnings since 2000. Twelve years ago it traded on a PER of 40 today it's 12.

Even buying the best businesses for the long-term won't produce satisfactory returns unless you buy them cheaply. This saying gets only half the equation right. BUSTED.

3. You never go broke taking a profit

Impossible to dispute, but it's the wrong question. A better one is: Will you get rich taking many small gains?

The best investors over many years make hundreds of per cent on their initial investment. What they don't do is sell a still-underpriced quality stock for, say, a 20 per cent profit.

The saying also neglects the fact that every investor makes losses. Larger profits on some stocks (letting your profits run) should eventually offset the inevitable smaller losses you make on others.

This cute little phrase neglects this larger truth. BUSTED.

4. Never try to catch a falling knife

A falling knife is easily recognised. A falling stock, unconstrained by the laws of physics, is anything but.

Sensible investors focus on the underlying value of the company, frequently seeing price falls as a reason for excitement. No one likes buying an investment only to watch it fall in value, but it's a necessary part of the game. BUSTED.

5. Cash is king

There are periods when holding large portions of your portfolio in cash is a great idea - 2006-7 was a recent example. But no one knows in advance.

The phrase presumes you can time the market, which we all know to be extremely difficult.

The alternative is to hold large portions of one's portfolio in cash all the time, which then subjects it to meagre returns. Over the long term, returns from shares are about twice that of cash.

There are times when it makes sense to hold a portion of one's portfolio in cash but over the long term shares are king and cash will turn you into a pauper. BUSTED.

6. You can't eat capital gains

This cliche leans on an element of truth but takes it too far. Dividend income from shares is generally safer and more consistent than capital gains, which can turn up one year and evaporate the next.

The saying, however, implies one can always rely on dividends. Yet dividends can be cut or abolished, especially in periods like 2008-09. You can't eat a cancelled dividend.

The phrase can also waylay unsuspecting investors to focus on the highest-yielding stocks at the expense of more durable opportunities. Paradoxically, such stocks are the ones most likely to see a dividend cut (the yield is often high for a reason).

Finally, the aphorism neglects to account for the tremendous power of capital gains, which generate real wealth and can help with groceries and other incidentals. BUSTED.

Nathan Bell is the research director at Intelligent Investor, This article contains general investment advice only (under AFSL 282288).

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