Financial markets are complex dynamic systems, populated by irrational and biased participants. Because of this, we have a tendency not only to misunderstand how the financial markets function, but we tend to buy into myths that often harm our financial well-being.
But by better understanding the financial markets, ourselves and the behavioural flaws that drive these persistent myths, we can increase our odds of achieving our financial goals. Here’s what investors need to watch out for:
1. You can’t be Warren Buffett
Over the past 30 years, the world’s greatest investor has come to be idolised. But the way Warren Buffett has amassed enormous wealth is often misunderstood. The myth of the simpleton from Omaha who just picks 'value' stocks has driven an entire generation to fall for the myth that they can replicate what Buffett does.
Make no mistake; Buffett is not a simple value-stock picker. What he has built is far more complex and resembles something that few retail investors can even come close to replicating.
Berkshire Hathaway, Buffett’s firm, essentially acts as a multi-strategy hedge fund. Berkshire engages in sophisticated insurance underwriting, complex fixed-income strategies, multi-strategy equity approaches and tactics that more resemble a private equity firm than a value-based brokerage account. Replicating this isn’t just difficult -- it might well be impossible.
2. You get what you pay for
Few things are more detrimental to portfolio performance than fees. Most mutual funds underperform a highly correlated index, yet they charge 0.8 per cent more in fees on average than a highly correlated index. That might not seem like much, but when you compound this at 7 per cent over 30 years, your total return gets reduced by 23 per cent. At that rate of return, an investor who buys $100,000 of a closet index fund and one who buys a highly correlated, low-fee index will amass, respectively, $590,000 and $740,000 over that 30-year period. Millions of investors are stuck in mutual funds that don’t outperform a benchmark index.
There’s a simple and irrefutable rule in markets: all assets are always held by someone. Therefore, in the aggregate, the performance of the market is what it is; no one 'beats' the market. So the investor who incurs greater fees, frictions and other inefficiencies will underperform the aggregate as well a peer who incurs fewer of these frictions. In finance, more expensive doesn’t necessarily mean better.
3. You should focus either on fundamentals or technical analysis
A great battle rages in financial circles between fundamental analysis and technical analysis. Fundamentalists believe you need to understand corporate fundamentals to predict how an asset might perform; technicians believe an asset’s past performance is the key to its future.
But this debate is like trying to determine whether it’s better to drive looking through the windshield or also utilizing the rear-view mirror. The truth is somewhere in-between, as both can be useful ways to be aware of the road. Be open-minded about financial markets. There are no holy grails and there’s value in various styles and approaches, including both fundamental and technical analysis.
4. The myth of ‘passive’ investing
There’s no such thing as a 'passive' investor. No one can realistically replicate the performance of a truly passive index over the long-term. Accordingly, we’re all active portfolio managers in some sense, whether it’s establishing a lump-sum portfolio at initiation, rebalancing, reinvesting, reallocating, and the like. We need to be aware of how these actions can be positive or negative.
It’s important to reduce fees and frictions, but not at the risk of oversimplifying the portfolio to the point where it’s counterproductive. The concept of passive investing is built on useful and sound principles, but often overlooks the fact that portfolio management is a process, not a passive undertaking.
5. The stockmarket will make you rich
Most market participants tend to think of their financial situation in nominal terms. But when you are looking at your portfolio performance, it’s imperative to think in real terms. View your portfolio performance by the return that goes into your pocket. That means backing out inflation, taxes, fees and other frictions that reduce nominal return.
The stockmarket is not what makes us rich. The people on the Forbes 400 list didn’t get wealthy flipping stocks in their brokerage accounts. They got wealthy building and running fantastic companies. The stock market can protect your wealth and help you maintain purchasing power, but it’s not the place where most of us are likely to make our fortunes.
6. You have to beat the market
It’s hard to avoid the allure of trying to beat the market; to outperform on a consistent basis by simply picking stocks. In truth, most of us are not going to strike it rich in the stockmarket and most of us shouldn’t even try.
You don’t need to beat the market. Attempting to beat the market means taking risks that are probably not appropriate. Instead, you need to allocate assets in a manner consistent with your financial goals of beating inflation, without exposing your portfolio to disruptive levels of risk. Beating the market is probably not only unattainable for most, but likely to encounter disastrous financial turbulence along the way.
7. ‘Stocks for the long run’ is the best strategy
You’ve probably heard about 'stocks for the long run' or 'buy and hold'. These concepts are usually sold to investors using misleading nominal historical returns, or the promise of climbing on the financial roller coaster at age 25 and getting off at age 65, whereupon you stroll into the sunset years.
Of course, this isn’t remotely how life works, and our financial lives should reflect that. Our financial lives are a series of events. You get married, buy a house, have children, send them to college, plan for retirement. Life happens, and investment portfolios should reflect this. We can’t just throw ourselves and our families into the stockmarket and hope it’s going up when our most important (and expensive) events occur.
Forget about the long run. There are only short sprints inside of a marathon. Planning a portfolio around the ideas of 'buy and hold' and 'stocks for the long run' look nice inside of an academic study based on 12 per cent annualized gains, but in reality often causes more financial pain than anyone deserves.
Cullen Roche is the founder of Orcam Financial Group and author of Pragmatic Capitalism: What Every Investor Needs to Know About Money and Finance (Palgrave Macmillan).
This article was originally published at MarketWatch.