I'm hardly the first to put together a list of investing myths, but I've been spurred to put together a list for two reasons. First, I've stumbled on a few of these lists lately and have been a little shocked at what some folks are trying to dismiss as myth. Second, it's the end of the year and as we careen toward the inevitable setting of 2011 resolutions, why not make sure we have facts, rather than tall tales, in mind when setting those goals?
Without further ado, here we go:
1. For higher returns, you need to take more risk
One of my personal favorites, this myth is related to the belief that mathematical computations can explain the real world and, in particular, stocks and the stock market. The calculation of "beta" is central to this myth. Beta is essentially a measure of how much a stock moves versus the rest of the market, and a stock that moves a lot more than the market is considered highly risky, while a stock that moves as much or less than the overall market is considered less risky.
The simplest way to address this is to think about a stable, quality company like Procter & Gamble. Now imagine that P&G's stock suddenly got walloped to the tune of 20%. Is the stock now more or less risky? If you ask beta, it's much more risky. But assuming all else stays the same, an intelligent investor would say that an investment in the stock is now much less risky as you're getting the same great company at a lower price. And you don't even need a calculator to figure that out.
2. In every trade there's a winner and a loser
This one isn't all that farfetched and it's one that I used to subscribe to. And, in fact, there may actually be a winner and a loser in some transactions. However, with many investors out there with many different investing goals and time horizons, I'm not so sure it's always as simple as one party being the smarty-pants while the other is the dunce.
Think about it this way. You decide to sell your shares of Coca-Cola
Who's the loser here? Sure the pension fund is buying at the higher price, but if the stock can deliver returns in the lower range that it is targeting, then the investment makes sense for the fund.
3. The market's too volatile to invest in good companies
One list of "myths" I stumbled on claimed that it's a myth that investing in good companies is the way to go. It said:
...today's market is a much more volatile environment for individual stocks; good companies can experience sudden, unforeseen problems that can tank their stock price by half or more in a just a few weeks.
Granted, there are plenty of different ways that you could define a "good company," but right off the top, this assertion seems like one heck of an exaggeration.
Can a major company see its stock drop like crazy in a short period? Sure, just look at BP
More importantly though, even in the case of BP's extreme situation the heady downside volatility created an attractive opportunity as investors got overly pessimistic about what the spill would mean for the company.
Meanwhile, Johnson & Johnson
In other words, not only is there still a case to be made for investing in high-quality companies, but the market's volatility may actually be a blessing for investors that are on top of their games.
4. Index funds are for losers
I recently got in a back-and-forth with another commentator about index funds. While I don't think that perfectly efficient markets make index funds an inevitable choice for every type of investor, I do believe that they're the best way to go for many types of investors.
So how do you know whether you should be going the index fund route? Be honest with yourself with regard to the effort that you put into your investing. Are you picking stocks based on a sound bite from Jim Cramer or a quick glance at a price-to-earnings ratio? Or are you actually taking the time to do real research like getting to the know company's business, reviewing financial reports, and studying up on the industry? If it's the former, you can save yourself some heartache down the road by simply investing in the entire market through index funds.
Start the New Year right
The New Year is right around the corner and that means that it's resolution time again. Why not think about giving these investment myths the axe before 2011 becomes official?
My fellow Fools think they've pinpointed the top stock for 2011. You can check out their pick by downloading their free special report.