Common misunderstandings about how investing works
Five common beliefs about investing sound sensible but can lead to costly decisions, along with the more careful ideas that tend to replace them.
The misunderstandings that do the most damage in investing are usually the ones that sound sensible. Each contains a true idea stretched too far, and that stretch can lead to decisions that cost money or cause people to abandon a plan at the wrong moment. Five of the most common are examined below, along with the more careful idea that tends to replace each one. The reasoning behind each correction is often more useful than the rule of thumb itself, because the reasoning carries over to situations the rule never anticipated.
Assuming a good investment always goes up
Many people equate a sound investment with one that rises steadily. Sound investments can still fall, sometimes for long stretches. A company with strong products can see its share price drop when expectations change, and a diversified fund can lose value during a broad market decline. The price path of any investment reflects expectations about the future rather than a promise of gains. A bond that pays a fixed interest rate, for example, can still fall in price when market interest rates rise, even though every scheduled payment is made on time.
A more careful idea is that a sound investment has a reasonable purpose, a time frame that fits and risks the owner understands. None of those features guarantees a rising price. Asking whether the price is likely to rise is a less useful question than asking whether the investment still makes sense if it falls and stays down for a while. That second question leads to better planning and to fewer surprises.
Believing market timing is a reliable skill
Market timing means buying before prices rise and selling before they fall. It sounds straightforward, but it requires getting two decisions right, and the moves that matter most often happen quickly and unexpectedly. Because a small number of strong market days often occur close to weak ones, investors who step out of the market to avoid a decline can miss part of the recovery that follows.
Trading to time the market also brings costs and possible taxes, and each exit and re-entry adds to them. Attempts to time the market can easily end up selling after a drop and buying after a rise, which reverses the intended result. A steadier alternative is to decide in advance how much to invest and when, then keep to that schedule rather than reacting to each headline.
Chasing last year's best performers
A fund or stock that rose sharply over one period attracts attention, and it is tempting to assume the trend will continue. Strong results are often the product of a particular set of conditions, and those conditions may not persist. Investors who buy after a strong run can end up holding an investment just as its momentum fades, and they may see a decline shortly afterward.
Comparing results over longer periods, looking at the risks and checking the costs usually gives a more complete picture than ranking investments by a single year. A ranking can also hide differences in how much risk was taken to achieve the result. An investment that led the list because it took large risks may be less suitable than one that grew more steadily, depending on the purpose of the money.
The same caution applies in reverse. An investment that has fallen sharply is not automatically a bargain, because the decline may reflect a real change in its prospects. Looking only at losses over a single period can lead to buying something that keeps falling, just as looking only at gains over a single period can lead to buying something that has already risen as far as its prospects allow.
Treating diversification as protection from every loss
Diversification spreads money across different holdings so that one poor result does not dominate the whole portfolio. That is valuable, but it does not prevent losses, because many holdings can fall at the same time when the broad market declines.
Consider an investor who owns fifty companies in several industries. One company's bankruptcy would cost only a small share of the portfolio, but a broad sell-off that pushes most of those companies lower would still reduce the total value noticeably.
Reading past performance as a promise
The phrase "past performance does not guarantee future results" appears in investment documents for good reason. A history of strong returns describes what has already happened under conditions that may not repeat. Good performance can reflect market conditions, luck, risk taken or a combination of factors that are hard to separate. Using past results as a forecast turns a description into a prediction.
A more useful habit is to ask what drove the results, whether those drivers are likely to remain and what the investment did during a difficult period. Those questions point toward the risks that a performance table does not show.
When you hear any investing belief, ask what would have to be true for it to hold, and what would happen if it did not. Replacing a catchy assumption with a specific question about purpose, time, cost and risk usually leads to more durable decisions.