This post was originally published on this site
Over the years, I have regularly addressed the psychological and emotional pitfalls that ultimately lead individual investors to poor outcomes.
The internet is littered with a stream of articles promoting the ideas of “dollar-cost averaging,” “buy-and-hold” investing and “passive-indexing” strategies to help you achieve your financial dreams.
However, as I addressed in “The Illusion of Declining Debt to Income,” if these are effective solutions, why are most of Americans so financially poor?
Here are some statistics from a recent Motley Fool survey:
Imagine how the 50th percentile of those ages 35 to 44 has a household net worth of only $35,000 — and that figure includes everything they own, any equity in their homes and their retirement savings to boot.
That’s sad considering those ages 35 and older have probably been in the workforce for at least 10 years.
And even the 50th percentile of those ages 65-plus isn’t doing much better; they’ve got a median net worth of around $171,135, and quite possibly decades of retirement ahead of them.
So what happened?
• Why aren’t those 401(k) balances brimming over with wealth?
• Why aren’t those personal E*Trade and Schwab accounts bursting at the seams?
• Why isn’t there a yacht in every driveway and a Ferrari in every garage?
It’s because investing does not work the way you are told. (Read the primer: “The Big Lie of Market Indexes.”)
Seven myths you are told that keep you from being a successful investor
1. You can’t time the market
Now, let me be clear. I am not discussing being all-in or all-out of the market at any given time. The problem with trying to “time” the market is “consistency.”
What I am discussing is risk management, which is the minimization of losses when things go wrong. While there are many sophisticated methods of handling risk within a portfolio, even using a basic method of price analysis, such as a moving average crossover, can be a valuable tool over long-term holding periods.
The chart below shows a simple moving average crossover study. The actual moving averages used are not important, but what is clear is that a basic form of price movement analysis can provide a useful identification of periods when portfolio risk should be reduced.
Again, I am not saying that such signals mean going 100% to cash. What I am suggesting is that when sell signals are given, it is time for some basic portfolio risk management.
If you use some measure, any measure, of fundamental or technical analysis to reduce portfolio risk as prices/valuations rise, the long-term results of avoiding periods of severe capital loss will outweigh missed short-term gains. Small adjustments can have a significant effect in the long run.
2. “Buy and hold” and “dollar cost average”
While those two mantras have been the core of Wall Street’s annuitization and commoditization of the investing business by turning volatile commission revenue into a smooth stream of income, they have clearly not worked for investors who were sold the “scheme.” Two of the biggest reasons for the shortfalls have been the destruction of investor capital and investor psychology.
Despite the logic behind buying and holding stocks over the long term, the biggest single impediment to the success over time is psychology. The behavioral bias that leads to poor investment decision-making is the single largest contributor to underperformance over time. Dalbar defined nine of the irrational investment behavior biases, but the two biggest are the herding effect and loss aversion.
Those two behaviors tend to function together, compounding investor mistakes over time. As markets are rising, individuals are led to believe that the current price trend will continue for an indefinite period. The longer the rising trend lasts, the more ingrained the belief becomes until the last of holdouts finally buys in, as the financial markets evolve into a euphoric state.
As the markets decline, investors slowly realize they are looking at something more than a “buy the dip” opportunity. As losses mount, anxiety pushes investors to try to avoid further losses by selling.
This behavioral trend runs counter-intuitive to the “buy low/sell high” investment rule and continually leads to poor investment returns over time.
3. More risk equals more return
Investors are always prodded to take on additional exposure to equities to increase the potential for higher rates of return if everything goes right. What is never discussed is what happens when everything goes wrong?
If you look up the definition of “risk,” it is “to expose something of value to danger or loss.”
As my partner Michael Lebowitz noted:
“When one assesses risk and return, the most important question to ask is: ‘Do my expectations for a return on this investment properly compensate me for the risk of loss?’ For many of the best investors, the main concern is not the potential return but the probability and size of a loss.
“No one has a crystal ball that allows them to see into the future. As such, the best tools we have are those which allow for common sense and analytical rigor applied to historical data. Due to the wide range of potential outcomes, studying numerous historical periods is advisable to gain an appreciation for the spectrum of risk to which an investor may be exposed. This approach does not assume the past will conform to a specific period such as the last month, the past few years or even the past few decades. It does, however, reveal durable patterns of risk and reward based upon valuations, economic conditions and geopolitical dynamics. Armed with an appreciation for how risk evolves, investors can then give appropriate consideration to the probability of potential loss.”
Spending your investment time horizon making up previous losses is not an optimal strategy to build wealth.
4. All the cash on the sidelines will push prices higher
How often have we heard this? I busted this myth in detail in “Liquidity Drain” but here is the main point:
“There are no sidelines. Those saying this seem to envision a seller of stocks moving her money to cash and awaiting a chance to return. But they always ignore that this seller sold to somebody, who presumably moved a precisely equal amount of cash off the sidelines.”
Every transaction in the market requires both a buyer and a seller with the only differentiating factor being the price at which the transaction occurs. Since this must be the case for there to be equilibrium in the markets, there can be no “sidelines.”
Furthermore, despite this very salient point, a look at stock-to-cash ratios also suggests there is very little available buying power for investors currently.
There is no cash on the sidelines.
5. Tax cuts will fuel the markets
We are told repeatedly that “cutting taxes” will lead to a massive acceleration in economic growth and a boom in earnings. However, as Lacy Hunt recently discussed, this may not be the case.
“Considering the current public and private debt overhang, tax reductions are not likely to be as successful as the much larger tax cuts were for presidents Ronald Reagan and George W. Bush. Gross federal debt now stands at 105.5% of GDP, compared with 31.7% and 57%, respectively, when the 1981 and 2002 tax laws were implemented. Additionally, tax reductions work slowly, with only 50% of the impact registering within a year and a half after the tax changes are enacted. Thus, while the economy is waiting for increased revenues from faster growth from the tax cuts, surging federal debt is likely to continue to drive U.S. aggregate indebtedness higher, further restraining economic growth.
“However, if the household and corporate tax reductions and infrastructure tax credits proposed are not financed by other budget offsets, history suggests they will be met with little or no success. The test case is Japan. In implementing tax cuts and massive infrastructure spending, Japanese government debt exploded from 68.9% of GDP in 1997 to 198% in the third quarter of 2016. Over that period, nominal GDP in Japan has remained roughly unchanged. Additionally, when Japan began these debt experiments, the global economy was far stronger than it is currently, thus Japan was supported by external conditions to a far greater degree than the U.S. would be in present circumstances.
“The outcome of tax reform/cuts at the tail end of an economic expansion may have much more muted effects than what the market has currently already priced in.”
6. Cash is for losers
Investors are often told that holding cash is foolish. Not only are you supposedly “missing out” on the rocketing bull market, but your cash is being eroded by “inflation.” The problem is the outcome of taking cash and investing it into the second-most-overvalued market in history.
I discussed the following in “The Real Value of Cash.”
The chart below shows the inflation-adjusted return of $100 invested in the S&P 500 SPX, +0.08% (capital appreciation only, using data provided by Robert Shiller). The chart also shows Shiller’s CAPE ratio. However, I have capped the CAPE ratio at 23 times earnings, which has historically been the peak of secular bull markets. Lastly, I calculated a simple cash/stock switching model that buys stocks at a CAPE ratio of 6 times or less and moves back to cash at a ratio of 23 times.
I have adjusted the value of holding cash for the annual inflation rate, which is why during the sharp rise in inflation in the 1970s, there was a downward slope in the value of cash. However, while the value of cash is adjusted for purchasing power in terms of acquiring goods or services in the future, the impact of inflation on cash as an asset with respect to reinvestment may be different since asset prices are negatively affected by spiking inflation. In such an event, cash gains purchasing power parity in the future if assets prices fall more than inflation rises.
While cash did lose relative purchasing power because of inflation, the benefits of having capital to invest at lower valuations produced substantial outperformance compared with waiting for previously destroyed investment capital to recover.
Much of the mainstream media will quickly disagree with the concept of holding cash and tout long-term returns as the reason to remain invested in both good times and bad. The problem is that it’s your money at risk and most individuals lack the time necessary to truly capture 30- to 60-year return averages.
7. If you’re not in, you’re missing out
Periods of low returns have always followed periods of excessive market valuations. In other words, it is vital to understand that investment timing affects your eventual outcome.
The chart below compares Shiller’s 20-year CAPE to 20-year actual forward returns for the S&P 500.
From current levels, history suggests returns to investors over the next 20 years will likely be lower than higher.
No one can rely on these myths for their financial future.
Again, if the myths above weren’t myths, wouldn’t there be a whole lot of rich people heading into retirement?
In the end, only three things matter in investing for the long term:
• The price you pay.
• When you sell.
• The risk you take.
Get any one of those three things wrong, and your outcome will be far less than you have been promised by Wall Street.
Lance Roberts is chief portfolio strategist and economist for Clarity Financial. He is host of “The Lance Roberts Show,” chief editor of the Real Investment Advice website, and author of the Real Investment Daily blog and Real Investment Report. Follow Lance on Facebook, Twitter and LinkedIn.