Amid the euphoria as stocks approach all-time record highs, new investors have started flooding back into the financial markets. Yet inevitably, many of those investors are making mistakes with their investments that could cost them substantial portions of their overall returns in the years to come. You need to make sure you aren't making the same mistakes.
One of the biggest false assumptions that less-experienced investors make is that whatever current trend exists will continue forever. Although some trends end up lasting a lot longer than skeptics would ever think possible, you nevertheless need to position yourself to understand the risks involved and have a viable exit strategy for how to handle the next trend change.
Let's focus on two areas where investors are relying too much on the past to guide their decisions and look at more viable and prudent ways of managing your portfolio.
1. Thinking that stocks will keep behaving the way they have since 2009.
Performance-chasing has always been a problem for investors of all skill levels, and you can see the same tendency to buy into high-performing asset classes in today's market behavior. Consider: Over the past four years, broad market benchmarks have more than doubled, yet it's only now that investors are getting back into stocks.
On one hand, that's a natural impulse. After all, those who liked stocks in 2007 when they were last at record highs saw the market's 2008 meltdown as a symptom of a broken financial system. Many of them were waiting for evidence that the system would fix itself before getting back into stocks, and watching the stock market reach toward new highs certainly seems like a sign of renewed health.
The problem with that theory is that in many cases, share prices reflect not only the past recovery but also huge expectations for the future. For instance, the multiples that Hovnanian (HOV 2.29%), Beazer Homes (BZH 0.53%), and a wide variety of other homebuilders' stocks now fetch are in part justified by the big increases in order and sales activity that the companies have seen. But they also carry positive expectations for continued growth forward, and anything that holds that future growth back could force those stocks back downward rapidly. To some extent, that situation is the same for the overall stock market.
2. Thinking that stocks will keep behaving the way they have since 2000.
At the same time, many investors have given up on stocks entirely. They argue that two major bear markets following the big boom of the 1990s has led to volatile markets that produce flat to lower returns for many stocks. With the Nasdaq Composite (^IXIC +1.63%) still 40% below its all-time highs, these investors point to developments like high-frequency trading as rigging the odds against them and making it impossible for individuals to compete with Wall Street professionals.
It's true that markets will rise and fall. But assuming that overall returns will be flat forever is just as big a mistake as thinking that markets will soar without pause forever. In the past, long periods of relatively flat performance like the 1970s have given way to boom periods like the 1980s and 1990s. Volatility will never go away, but smart investors understand that volatility is what produces huge return opportunities for those willing to take risks at the scariest times.
Moreover, it's all too easy to neglect the impact of dividends in stock markets that appear to be flat or down. For instance, ignoring dividends, Microsoft (MSFT +2.11%) has seen its stock price fall almost 15% in the past five years, as slowing PC demand and some vulnerability in its core operating system and office software spaces has emerged. Yet when you consider the impact of dividends, the stock has managed to eke out a modest positive total return over that time frame. Similarly, Merck's (MRK 2.37%) share price is down by a quarter over the past decade, as the company has seen many drugs recently fall off the patent cliff. Yet the stock has produced a 20% total return over that period thanks to high dividend yields.
What to do
History is useful in analyzing stocks and considering strategy. But if you rely too much on history, you'll make the huge mistake of assuming that history always repeats itself. By looking at history as a rough outline of possible outcomes rather than as a timeline that will inevitably play out again, you'll be best able to adapt to the new conditions that investors will face in the future.
Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitter @DanCaplinger.
