Many investors make use of the massive amount of information available about financial markets, assets, and products when making investment decisions. And because there are numerous possible sources of information, investors tend to make their own decisions based in large part on common sense and simple rules of thumb.
While this is reasonable, Shane Oliver, Sydney-based head of investment strategy and chief economist at AMP Capital Investors, points out why in many cases these can result in either investors missing opportunities or losing money.
In a recent report, Oliver highlights common myths and mistakes that investors make:
Myth #1: High unemployment will prevent an economic recovery.
This argument is wheeled out every time there is a recession, but if it were correct then economies would never recover from recession but simply spiral down, Oliver says. He notes that the impact of lower interest rates on lower mortgage bills, and subsequently, higher household discretionary income eventually offsets the fear of unemployment for the bulk of people still employed. It is normal for unemployment to keep rising during the initial phases of an economic recovery as businesses are slow to start employing again, he adds.
Myth #2: Business won't invest when capacity utilisation is low.
Capacity utilisation is low in a recession simply because spending -- including business investment -- is weak, Oliver says. So when demand turns up, profits improve and this drives a pick-up in business investment which in turn drives up capacity utilisation, he adds.
Myth #3: Corporate CEOs, being close to the ground, should provide a good guide to where the economy is going.
Senior business people are often overwhelmingly influenced by their own sales figures but have no particular lead on the future, Oliver says. He notes that in the latter stages of the recessions in the early 1980s and early 1990s, anecdotal comments from Australian CEOs were generally bearish just as recovery was about to take hold.
Myth #4: The economic cycle is suspended.
A common mistake investors make at business cycle extremes is to assume that the business cycle won't turn back the other way, Oliver says.
Myth #5: Crowd support for a particular investment indicates a sure thing.
This safety in numbers concept has its origin in crowd psychology. The only problem with it is that while it may work for a while it is usually doomed to failure, Oliver says. If everyone is bullish and has bought into the asset there is no one left to buy in the face of any more good news, but plenty of people who can sell if some bad news comes along, he notes.
Myth #6: Recent past returns are a guide to the future.
This is another classic mistake that investors make which is again clearly rooted in investor psychology. Reflecting the difficulty in processing information, short memories and wishful thinking, recent poor returns are assumed to continue and vice versa for strong returns. The problem with this is that combined with the safety in numbers myth, it results in investors getting into an investment at the wrong time when it is peaking and getting out of it at the wrong time when it is bottoming, Oliver says.
Myth #7: Strong economic growth and strong profit growth are good for stocks and poor economic growth and falling profits are bad.
This is generally true over the long term and at various points in the economic cycle, but at cyclical extremes it is usually very wrong, Oliver says. The big problem is that share markets are forward looking, so when economic data is really strong -- measured by strong economic growth, low unemployment -- the market has already factored it in, he notes.
Myth #8: Strong demand for a particular product produced by a stock market sector should see stocks in the sector do well and vice versa.
While this might work over the long-term and for a while it suffers from the cyclical nature of demand, Oliver says.
Myth #9: Budget deficits drive higher bond yields.
The logic behind this is simple supply and demand. If the government is borrowing more (higher budget deficits) then this should push up interest rates (the cost of debt) and vice versa. But Oliver says it often doesn't turn out this way because periods of rising budget deficits are usually associated with recession and thus, weak private sector borrowing and falling inflation and interest rates so that bond yields actually fall not rise.
Myth #10: Having a well diversified portfolio means that an investor is free to take on more risk.
A common strategy has been to build up more diverse portfolios of investments less dependent on equities and with greater exposure to alternatives such as hedge funds, commodities, direct property, credit, infrastructure, or timber. This generally led to a reduced exposure to truly defensive asset classes like government bonds. So in effect, Oliver notes, investors have actually been taking on more risk helped by the comfort provided by greater diversification.
Myth #11: Tax should be the key driver of investment decisions.
There is no point negatively gearing into an investment so as to get a tax refund if it always makes a loss, Oliver says.
Myth #12: Experts can tell you where the market is going.
Economic and investment forecasts are often seen as central to investing, but sometimes they are badly flawed, Oliver says. Forecasts for economic and investment indicators are useful, but need to be treated with care, he adds.
"The myths might appear logical and consistent with common sense, but they all suffer often fatal flaws which can lead investors into making the wrong decisions," Oliver says. "The trick to successful investing is to recognise that markets and economies are highly complex, that they don't go in the same direction indefinitely, that markets are usually forward looking and that avoiding crowds is healthy."