Three investing myths that refuse to die

Here we explain three of the most common investing fantasies and the reality behind them.

Myths can take a long time to die, and sometimes never do. Various investing strategies and catch phrases promise to make you big, fast returns, and their potential is often too seductive to abandon. Here are three of the most pervasive investing myths that can damage your portfolio.

Risk equals reward

Like most myths that refuse to die, there's an element of truth buried in the phrase 'risk equals reward'. In general, investors require higher compensation for taking on additional risk – the Australian Government is going to get a better rate on its borrowings than your unemployed cousin Barry.

The 'risk equals reward' rule also tends to hold when it comes to whole asset classes – stocks are more volatile than property, which itself is more volatile than bonds and cash. A chart of these assets over the past 100 years shows that returns have followed that order as well, with stocks being the top performer and cash the worst.

However, this is where the theory ends. When you are choosing individual stocks or funds, higher risk isn't automatically compensated, it needs to be ‘priced in'. It's important to differentiate between underlying business risk and investment risk, which is dependent on the price you pay. A small cap miner may be riskier at the business level than, say, Woolworths (ASX: WOW) due to a higher chance of bankruptcy. But if an investor bought Woolworths for $1 trillion, that would be a far riskier move with no hope of earning a decent return compared to an investor buying the miner for a tenth of its net tangible assets.

Value investing works because the lower the price you pay relative to a company's intrinsic value, the larger the margin of safety (ie lower risk). What's more, for a given set of cash flows, as the price you pay goes down, the return on investment rises. If anything, risk and return are two sides of a see-saw: as the share price goes down relative to intrinsic value, and the margin of safety widens, the prospective return goes up. 

A low share price means it's undervalued

Given all that, it may seem like lower share prices in absolute terms – 1 cent versus $10 – might therefore be better. After all, a stock selling for just 1 cent only needs to go up a cent and you'll have doubled your money.

The trouble is that stocks represent fractional ownerships of a company and that company can cut its pie into as many slices as it wants. Share prices aren't comparable, one company to another.

Let's look at Woolworths again. The stock is currently trading at around $25 and there are 1.3bn shares outstanding. To work out the company's market capitalisation (its current valuation as a whole), we multiply the share price by the number of shares and reach $33bn.

However, there's nothing stopping the company from ‘splitting' its shares overnight, so that tomorrow there are 2.6bn shares outstanding. The company itself hasn't changed – it would still be valued at $33bn – just the number of shares, so the share price would halve to $12.50. In theory, the company could split its share count so that one current share becomes 100, and the share price would then be a lowly 25 cents – none of which has any impact whatsoever on the company's operations or its total market value.

What matters isn't the share price itself, it's where it stands relative to a stock's underlying intrinsic value, which is a function of all the cash it will throw off between now and judgment day. You can have $100 stocks that are undervalued and 5 cent stocks that are overvalued.

Your financial advisor is there to help

‘It's difficult to get a man to understand something when his salary depends on him not understanding it,' said Upton Sinclair.

Around 85% of the 18,000 financial planners in Australia are associated with one of the big banks or AMP. Make no mistake, they are being compensated by these organisations, usually through commissions or rebates, even if they don't have big Westpac banners in their office. The fact is that most financial planners are there to sell you financial products, rather than provide advice that is exclusively in your best interest.

There are a few independent financial planners out there, but they can be hard to find. At the very least, check whether your advisor is a certified financial planner (the letters CFP usually appear after the person's name on their business card). This is a more rigorous course than most training programs. It's also worth asking whether the advisor is a flat fee-for-service provider, which avoids their remuneration being tied to product sales. If your advisor is on anything other than a fixed salary, odds are that other incentives are biasing his or her advice. For more tips on how to find a good advisor, see Six questions to ask your financial planner.

Want access to our latest research and new buy ideas?

Start a free 15 day trial and gain access to our research, recommendations and market-beating model portfolios.

Sign up for free

Join the Conversation...

There are comments posted so far.

If you'd like to join this conversation, please login or sign up here

Related Articles