The Great Myths of Investing

GreatMythsAs the great Mark Twain (may have) said, “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.” That’s particularly true in the investment world because we know, to a mathematical certainty, that avoiding errors provides more bang for the buck than making correct calls and generating outperformance. Fixing what we “know for sure that just ain’t so” provides a remarkable opportunity for investment success.

On the other hand, it simply doesn’t make a lot of sense to spend enormous amounts of time and energy looking for a strategy or a manager that might (but probably won’t) outperform by just a little bit. As the great Spanish artist Pablo Picasso put it, “Every act of creation is first of all an act of destruction.” What we want to do is to find the next great investor, the terrific new strategy, the market sectors that are about to heat up or the next Apple. But what we should do is eliminate the things that make it so hard for us to get ahead. Accordingly, I will highlight some of the great myths of investing — ideas that lots of people, alleged experts even, claim to be true and act as as though are true “that just ain’t so.”

There are lots of myths at work in our lives, of course, falsehoods that are often believed and which are used to further a favored narrative. But George Washington didn’t really cut down a cherry tree and wax eloquent about not telling a lie as a consequence. Isaac Newton didn’t come up with his theory of gravity because an apple fell on his head. Columbus didn’t discover that the earth was round (that had been established centuries before). Ben Franklin didn’t fly a kite in a storm and discover electricity. And Einstein never flunked math. If any of these are news to you, I’m sorry to have had to break it to you.

Such myths persist because they “work” in some way. Their story elements — ease of recall, readily adaptability, explanatory power — make them useful and even important.  But utility and truth are hardly the same things and neither are utility and helpfulness.

So here is my list of the top ten great myths of investing. Since they aren’t true and are indeed damaging, if you can eliminate them from your mind and your investment process, your results will necessarily improve.

Myth #1: You can predict the future. Wall Street’s top strategists expected the S&P 500 to rally by 10 percent in 2015, for interest rates to rise dramatically and for the price of oil to go up. So much for the ability of even alleged experts to predict the future. There are simply too many variables at work and in play to make meaningful predictions about near-to-intermediate term market performance. The investment management business recognizes this problem, but for them it’s a marketing difficulty. Thus there remain many market-timing and stock-picking schemes pushed at customers every day, often called something else entirely. The great William Bernstein states the case really well. “There are two kinds of investors, be they large or small: those who don’t know where the market is headed, and those who don’t know that they don’t know. Then again, there is a third type of investor – [an] investment professional, who indeed knows that he or she doesn’t know, but whose livelihood depends upon appearing to know.” If your investment strategy requires you to predict the future, you might want to re-think it.

Myth #2: The markets are efficient. It’s preposterously easy to falsify this claim, often made by academic finance. Simply look at the chart below, from October of 2015, and try to maintain the idea that markets are efficient in any aggregate sense. There are often minimal differences in intrinsic value of companies before and after major price changes in their stocks, driven by the emotion. However, I also hasten to add that the ease with which one can falsify the efficient markets hypothesis is entirely matched by the difficulty faced by investors in trying to beat the market. It’s monumentally difficult to exploit even obvious market inefficiencies (most often because they seem obvious only in retrospect). Since 1928, stocks have been in at least a 10 percent drawdown 55 percent of the time, but that hasn’t stopped many of us from panicking each and every time.

Outlook A

Myth #3: We’re rational, utility-maximizing creatures. This myth is also propagated by academic finance and also supported by the chart above. Anyone with even an ounce of self-awareness knows we’re anything but rational far too often. We are driven by emotions such as fear, greed and ego and beset by myriad cognitive flaws that make it monumentally hard for us to make good decisions, especially about money. Anyone who lived through the dotcom bubble (!) can only laugh at the silly idea that we’re cool rationalists. On our best days, when wearing the right sort of spectacles, squinting and tilting our heads just so, we can be observant, efficient, loyal, assertive truth-tellers. However, on most days, all too much of the time, we’re delusional, lazy, partisan, arrogant confabulators. Plan accordingly.

Myth #4: Free lunches are readily available. Quarter after quarter, year after year, the vast majority of money managers underperform the market. Even worse, those who do manage to outperform over a given period are unable to repeat that success over subsequent periods. There are no free lunches in the investment world. The closest thing we have to one is diversification, which works because free lunches are so rare. The theory behind diversification is simple: Don’t put all of your eggs in one basket. A single holding has huge potential for gains if the right instrument is selected, but even huger risks (because investing “home runs” are so hard to come by). In general, the greater a portfolio’s diversification, the lower its risk. Lower risk is a good thing, but only if the portfolio’s potential return is healthy enough to meet the client’s needs. Fortunately, a well-diversified portfolio captures most of the potential upside available with much lower volatility. Charlatans peddle the idea that the markets offer lots of free lunches (and free returns). Don’t be fooled.

Myth #5: I’m different (special even!). We all like to think that we live in Lake Wobegon, where all the women are strong, all the men are good-looking and all the children are above average. We like to think that the usual rules of investing and behavior simply don’t apply to us. The typical person can’t control his or her emotions, but I can. It’s really, really hard to beat the market, but I can. Almost nobody can pick the best managers ahead of time, but I can. Like Yogi, we think we’re “smarter than the average bear.” Academics believe it. Finance professionals believe it. And consumers believe it. But there’s not a shred of evidence to support it.

Myth #6: Fees don’t matter. That this myth is almost always implicit doesn’t make it any less of a myth (“because I’m worth it”). Neither does the sad reality that many consumers will be less likely to choose a lower fee product or service because they tend to equate price with value. The bottom line is that costs are the best indicator we have of investment success or failure (do I need to add that lower is better?). Fees do matter. A lot.

Myth #7: You can time the market. I’ve never known anybody who can time the market. I’ve never known anybody who knows anybody who can consistently time the market. No research supports the idea that it’s possible. Yet tactical management is a market (and marketing) staple. Whatever one thinks of his economic policies, John Maynard Keynes was, by any measure, one of the great investors of all-time. Yet even he did poorly until he gave up trying to time the market. Warren Buffett doesn’t even try. You shouldn’t either.

Myth #8: Complexity proves expertise. Academics fail here: “Page after page of professional economic journals are filled with mathematical formulas leading the reader from sets of more or less plausible but entirely arbitrary assumptions to precisely stated but irrelevant theoretical conclusions” (Nobel laureate Wassily Leontief, writing in Science). But the key users of this myth are those in the professional class who offer complexity to try to justify their ongoing existence and their (high) fees.

Meanwhile, the behavioral research is clear that too many choices and too much complexity lead to poor choices. I can’t say it any better than Oliver Wendell Holmes, Sr.: “For the simplicity on this side of complexity, I wouldn’t give you a fig. But for the simplicity on the other side of complexity, for that I would give you anything I have.” Yet perhaps Einstein did: “Everything should be as simple as possible, but no simpler.” Our world is complex and getting more so. The investment world is now exceedingly complex and going faster every nanosecond. If we’re going to succeed, we need to make things as simple as possible (if no simpler).

People facing complex problems generally make better decisions using simple heuristics or rules of thumb rather than complicated (and falsely precise) calculations. That’s the best approach when one can’t list all the possible alternatives and consequences, much less their probabilities. Scientists at the RAND Corporation have developed a set of practical principles for coping with complexity and uncertainty — to give us a chance to learn, to adapt, and to shape the future to our liking. Simplicity and flexibility are key. Complexity is not.

Myth #9: Risk and volatility are the same thing. Risk and volatility are hardly the same thing. Using volatility as a stand-in for risk makes the requisite academic finance equations work out neatly and all, but since nobody is bothered by upside volatility, it isn’t even a very rough approximation. Moreover, in the real world, buying a highly volatile market that is extremely cheap (think March of 2009) is among the safest plays imaginable. And, practically speaking, the only risk that really matters in the long-run is the permanent loss of capital. Measuring volatility doesn’t help much in avoiding that.

Myth #10: High probability is practical certainty. Due to complexity and the wild randomness it entails, the investment world — like weather forecasting — offers nothing like certainty. Investing is a probabilistic enterprise. Since certainty is even rarer than high risk-free returns, we’re left trying to make the best decisions we can based upon the knowledge we have. If we do that extremely well, we might be right most of the time, but still a long ways away from all of the time. The improbable — the highly unlikely even — happens and happens surprisingly often. That’s why the risk management programs in place during the financial crisis failed so spectacularly. They assumed that because an event or series of events were both highly improbable and had never happened before, they wouldn’t and perhaps couldn’t happen. As every blackjack player recognizes, making the “right” play (probabilistically) does not ensure success. The very best we can hope for is favorable odds and that over a long enough period those odds will play out (and even then only after careful research to establish the odds). That we don’t deal well with probabilities makes a difficult situation far, far worse.

We love confident certainty and a tidy resolution. That’s why we are so prone to believing myths (like the myth of high returns with low risk). We so badly want to believe that we have (finally) figured out the path to investment success that we keep making the same mistakes over and over again. The great Russian novelist Fyodor Dostoyevsky offers a better approach: “Above all, don’t lie to yourself. The man who lies to himself and listens to his own lie comes to a point that he cannot distinguish the truth within him, or around him, and so loses all respect for himself and for others.” Disavow these great myths and adjust your investment process accordingly. Your future results will be much, much better if you do.

22 thoughts on “The Great Myths of Investing

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  2. Why this constant reference to ‘academics’? There are many academic schools of thought. EMH is losing ground to behavioral theories. I think active management (myths #6, #7) does more damage to average investors than academics do. Other than that, good article!

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  4. Excellent piece. One thing I do disagree with. The ideas of markets not being efficient. I think markets are wonderfully efficient, if there are more sellers than buyers, the price drops and vice versa. – The actual problem is we confuse efficient with rational explanations for events. Sharp moves, spikes in volatility, liquidity vacuums, do not conform with what we think are efficient and rational markets. It is our view of efficient and rational markets which is wrong. Equally I do share your perspectives on the EMH, as does pretty anyone who has worked in the markets. Markets are driven by emotion, and sentiment, as much as they are driven by weighing up fundamental drivers of value, which themselves are subjective concepts rather than objective scientific data.

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  11. i stopped reading at : “There are often minimal differences in intrinsic value of companies before and after major price changes in their stocks, driven by the emotion.”

    The value is subjective. There’s no such thing as intrinsic value. Reading carefully more of academic papers prevents from making such simple mistakes of reasoning. In fact, what you say here has little to do with the efficient market hypothesis and all its implications.

    • The fact that smart and reasonable people might disagree about what fair (intrinsic) value should be in no way precludes the idea that it exists. Otherwise, there would be no reason to undertake Graham & Dodd analysis, which is designed to uncover precisely that.

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