People love to share stock market myths disguised as wisdom about the best investing strategies. Good investors will instead focus on tried-and-true portfolio allocation principles to make sure that they maximize long-term returns. Recognizing the flaws in these three stock market myths can help you manage risks and dodge common pitfalls.
1. Cheap stocks are the same thing as value stocks
Most people have heard that they should "buy low, sell high." That much might seem obvious, but the actual implementation of this strategy is an entire additional layer of difficulty. A complicated and necessary step is identifying stocks with attractive prices and the potential for growth. This is the keystone of value investing, which involves either buying stocks that trade at a discount to their intrinsic value or finding stocks with attractive valuation ratios relative to peers. That's a time-consuming challenge at the very minimum, and it could be impossible for investors who are not financial professionals.
Image source: Getty Images.
Cheap stocks with significant upside do exist, but many such stocks are actually value traps. Value traps appear inexpensive, but they are actually appropriately reflecting the risks facing the company. These companies are generally experiencing slow growth or even contraction, and they often have significant financial obligations in the form of debt.
In extreme cases, they are facing imminent losses from bankruptcy, regulatory fines, or major lawsuits. JC Penney was a famous value trap earlier this decade. There have also been numerous biopharma companies with promising drug candidates that failed to clear clinical trials that have fallen in this category. Cheap stocks with great return potential are out there, but cheaper stocks aren't always better buys.
2. Indexing is always the best strategy for individuals
Much has been studied about active versus passive investing, and the efficiency of index investing has been demonstrated over the past several decades. A wide array of ETFs and mutual funds have been launched to track a variety of stock indexes as a result. Most active fund managers have failed to outperform the market as a whole over the long term, especially after factoring in the high expense ratios required to run an actively managed fund. Passive indexing allows investors to grow with the market, with minimal trading and management fees incurred to erode returns.
Despite all of these clear advantages, indexing isn't always the best strategy. The stock market would not function properly without active participants trading stocks at values that reflect their future financial performance. Furthermore, investors with large enough portfolios can overcome certain fixed costs associated with active management while benefiting from additional management techniques such as tax loss harvesting, which helps reduce tax liability without fundamentally altering allocation.
Finally, while indexing is shown to produce favorable results long-term, active management often outperforms passive funds during bear markets and volatile periods. At the very least, investors with enough time to manage their portfolios should consider a hybrid model that doesn't require bearing the full brunt of bad markets during tough times.
3. You should invest in what you know
Many people have heard that they should invest in what they know. There may be a nugget of wisdom buried there, but it is ultimately misleading for the vast majority of individual investors.
First, there is a limit to how much anyone can know. Limiting your investments to the handful of companies or industries with which you're intimately familiar will almost certainly lead to a portfolio with very little diversification.
Secondly, being an expert in a certain field does not necessarily translate to proper financial analysis. A company with the best product and fantastic growth prospects may be completely mismanaged from a financial standpoint, and someone inside the industry could easily overlook financial health risks that would be obvious to a professional investor.
Consider someone whose profession and hobbies made them very well-versed on the internet industry in 1999. Someone focusing on this narrow slice of the economy may not have realized that internet company stock valuations were reaching unprecedented levels at the time, and that many of these investments were not sustainable. When the dot-com bubble burst, they certainly would have been thankful to hold a diversified portfolio with exposure to other sectors.
Having special knowledge of a company or industry can be helpful for evaluating some investments, but it can't be the backbone for portfolio building, because that level of knowledge is too limited.
Ultimately, rules of thumb and cliches grow from some sort of truth. However, the best investing approach always involves adhering to a handful of core principles that all good professionals share. Portfolio diversification, periodic rebalancing, and risk-sensitive allocation are among these principles, and they should guide your investing activity more than any of the popular myths.
