“It ain’t what you know that gets you into trouble. It’s what you know for sure that just ain’t so.”
Mark Twain
The financial markets may penalise ignorance, but as Twain suggests, false knowledge can be a whole lot more deadly. What follow are half a dozen investment truisms that simply aren’t true.
1. Cheaper = better
The principles of “value” investing would suggest cheaper is better. But it’s not always so. There is probably some inverse correlation between low management fees and consequent returns – but this is hardly an iron law. Low fees can also lead to overtrading (and poor subsequent returns as a result). US money manager Ken Fisher points out that investors into funds with no sales load (commission) tend to do worse than either the funds themselves, or the wider market.
Why? No-load investors hold their positions for an average of a year and a half, whereas investors into load funds hold their positions, on average, for seven years. Lower fees tend to encourage investors to overtrade and try (and usually fail) to time the markets. So if you’re paying for active management, don’t shop solely on price (especially in niche markets).
2. Inflation = higher prices
Not so, as Austrian school economists will tell you. Inflation is, first and foremost, a rise in the money supply. As more money gets printed, it will tend to drive up prices for goods and services, but that later “inflation” is a second-order effect. As the great Austrian economist Ludwig von Mises observed: “The most important thing to remember is that inflation is not an act of God, that inflation is not a catastrophe of the elements or a disease that comes like the plague. Inflation is a policy.”
3. Higher GDP = better returns
This is a stubborn belief for which there is no objective proof. A 2005 study across more than 50 countries by London Business School academics Dimson, Marsh and Staunton, going back in some cases to 1900, found no evidence of a stable link between GDP growth and equity returns. In many countries, wealth and growth prospects are concentrated in unlisted, family businesses, which by definition cannot feature in stock indices. The UK stockmarket has a history of decent returns even as UK GDP has been something of an international laggard.
4. No one ever lost out taking a profit
Tell that to Ronald Wayne. Wayne was a co-founder of Apple Computer who sold his 10% stake in the company in 1976 for $800. This quote, attributed to the American financier Bernard Baruch, is clearly accurate in a very narrow sense. But it touches on the psychology of investing, whereby we are often so reluctant to take a loss that we invariably bank our profits too soon.
The next eight words may be the most valuable in investment: “cut your losses and let your winners run”. This is a principle exploited very successfully by systematic trend-following funds.Markets have a tendency to surprise, and some of those surprises will be nice ones.
5. Bonds are safer than stocks
There are good historical reasons to buy bonds. High-quality bonds offer the promise of capital protection and regular income. However, I stress the word “historical”. The game has changed. A 30-year-plus bull market has driven bond yields into the floor, and in some cases beneath it. At the same time a 40-year-plus credit bubble has seen the quality of most sovereign borrowers deteriorate markedly. Bonds now, in most cases, represent return-free risk. There’s an argument for any unconstrained investor having an allocation to high-quality bonds (if they can be found), and that argument is deflation (falling prices). But in most other economic environments, a portfolio of high-quality, dividend-paying stocks, bought at a fair price, will generate altogether more attractive returns. In the years to come, many bond investors are likely to lose their shirts. They can’t say they haven’t been warned.
6. Risk = volatility
This is Nobel prizewinner Harry Markowitz’s fault. In an article in 1952 (“Portfolio Selection”), he essentially equated volatility (the ups and downs of an investment) with risk. Since then, portfolio managers have tended to do the same thing. Earlier thinkers knew better. As Guy Fraser-Sampson points out in his challenge to conventional investment theory The Pillars of Finance, the great economists and thinkers Frank Knight, von Mises and John Maynard Keynes never dared to define risk, but for them it certainly wasn’t volatility. They also believed and stated that one cannot use a mathematical model to forecast future investment outcomes. A more nuanced perspective than Markowitz’s would suggest that risk be best defined as the likelihood of a permanent loss of capital. Volatility is merely, in the shorter term, the equivalent of noise.
• Tim Price is director of investment at PFP Wealth Management. He writes The Price Report newsletter with Doug Pritchard.
Category: Market updates