For many, investing is a mysterious endeavor that can be comprehended only by experts. But that’s not actually the case; it’s actually not that complicated. But for many, a big obstacle to understanding investing – and to investing effectively – is a swirl of myths.
Research shows that these myths are one reason that investors typically get low returns, compared with the overall market. Various studies by Dalbar, Inc., a prominent financial research firm, show that for the 20-year period ended Dec. 31, 2019, the S&P 500 Index returned 6.1% annually, compared with 4.3% for the average stock mutual fund investor. That’s a substantial difference, especially when accounting for the effects of compounding.
If all these investors had just put their money in an S&P 500 index fund and remained invested, they’d have done significantly better. Instead, they made various investing errors, many of them driven by their belief in investing myths.
Here are a few of these myths:
Actively managed mutual funds outperform passively managed funds.
This simply isn’t true. There’s a mountain of credible evidence from objective academic studies that over the long term, the majority of passively managed mutual funds — known as index funds because they track market indexes — generally outperform actively managed funds, in which managers speculate by picking individual stocks. In so doing, they try to outsmart the market.
This is akin to gambling in a casino. In contrast, by building a well- diversified, global portfolio of low-cost index funds, you’re able to invest in the entire global market and thus capture its returns. This is like owning the casino versus playing in it because these investors aren’t at the mercy of their stock picks.
Buying an annuity is a good idea.
Although there are exceptions, these products are generally aggressively sold because of the commissions earned by salespeople. Unfortunately, most annuities sold are complex products by insurance companies. They’re usually quite expensive and highly inflexible contracts with long periods that involve steep surrender penalties. These products, which use various means to effect growth, can be highly lucrative for not only insurance companies, but also for those who sell them, as upfront commissions are currently as high as 8%.
A Congressional study in 2015 revealed the annuity industry as being rife with conflicts of interest that lead to significant profits for vendors and salespeople, much to the detriment of consumers. There are some laws on the books relative to salespeople’s compensation. But this study shows how the industry has been exploiting loopholes in these laws. As a result, American consumers are sometimes saddled with inferior products for high fees. The Securities and Exchange Commission even issued an Investor Alert to warn consumers.
Although there may be some rare occasions where certain types of low-cost annuities make sense, the study’s results amount to a loud warning: Buyer beware.
Hedge funds are desirable.
Many people with modest incomes wish they could get into a hedge fund because they believe the myth that this is a good investment available to the investing elite.
For the average investor, nothing could be further from the truth. A survey of the performance of hedge funds from 1994-2005 concluded that returns were about the same as the S&P 500 index—but with substantially more risk.
And because of astronomical fees involved, investors’ net returns—the gains investors actually get to keep after expenses—are usually much lower. Hedge fund managers have long operated by the principle of 2 and 20. This means a high annual fee of 2% on assets under management (no matter what happens), and the outrageous arrangement where the manager keeps up to 20% of any profits before distributing the rest to investors.
Though some investors have done OK in hedge funds, this has been rare. The managers of these investing black holes, of course, do quite well.
Knowing when to move money in and out of the market is the key to getting good investment returns.
This is the myth of market timing. But once again, as empirical academic evidence has clearly shown, the market’s movements over the short-term are completely random. So there’s no way to know what will happen. Yet, many investors try to time their investments.
Historically, the market has risen sharply on just a few random days, and this accounts for the bulk of longer-term returns, so it’s paramount to be invested on those days. Thus, time in the market can get results—not timing the market. Even many institutional investors’ have a poor record in their attempts to time the market.
Unfortunately, these myths and others are embraced by too many, ultimately leading to poor outcomes and disappointment. A better path is to adopt an evidence-based strategy guided by a solid personal financial plan.
Tim Decker is president of ISI Financial Group (www.isifinancialglroup.com), a wealth management firm in Lancaster, and a fee-only financial planner (he sells no products). His weekly call-in radio show, Financial Freedom, airs Saturdays at 10 a.m. on WHP580 AM.