How much do you really know about successful investing? Many people think they know more than they actually do. Consider the following seven investment myths and realities:
Myth #1: "Any kid with a computer can buy good stocks." Many people believed that virtually anyone could pick winning companies during the IPO and tech stock mania of the 1990s. In reality, picking investments, particularly stocks, is hard work. It takes patience and discipline and research, using tools such as company annual reports and library references such as the Value Line Investment Survey.
Myth #2: "The expected return on stocks is 20%." During the late 1990s, people got used to investment returns on major stock market indices of 20% or more. The reality is that the historical return for stocks, as measured by the Standard and Poor's 500 stock index, is around 11%. In short time frames, however, the stock market is very volatile and investors can lose money.
Myth #3: "All you [a company] need is a good story." Many investors obviously believed this during the 1990s, especially with respect to dot com stocks. They thought that start-up Internet companies without any proven track record or earnings were, nevertheless, a good buy. Many firms, such as dr.koop.com and pets.com, have long since folded. The reality is that company earnings matter. The best bets for investors are proven companies with a low price/earnings (P/E) ratio that are growing faster than their industry peers.
Myth #4: "The new economy has the edge." Many people believed that dot coms and other start-ups would revolutionize the business world because they would have lower expenses relative to established "brick and mortar" firms. In reality, "old economy" firms often have an edge due to economies of scale and the fact that they have been involved in their industry sector for many years.
Myth #5: "Buy and hold your investments." What this really means for many people, is to "buy and ignore." The reality is that, sometimes, you need to sell an investment. It is a good idea to have pre-determined "exit strategy," such as selling a stock after it drops by 10% or 15% or after a change of management or after two consecutive quarters of negative earnings.
Myth #6: "Buy on the dips." This thinking became fashionable during the extended bull market of the late 1980s and 1990s as investors saw stocks quickly bounce back time and time again after brief declines. The reality is that you need to know what you're buying. Just because a stock drops in price doesn't mean that it's a good value. Some stocks never recover and it takes research to uncover those that have the potential to turn around.
Myth #7: "Buy what you know." This myth exploded in the 1980s after press reports about successful mutual fund manager, Peter Lynch, buying companies that made products that he and his family were familiar with. What was lost in media reports, however, was the fact that the Fidelity Magellan Fund, which he managed, often had 1,400 companies in its portfolio and extensive research capabilities. Small investors concluded that they, too, could pick winning stocks based solely on what they know. This is a common behavioral finance error called "overconfidence" where people put too much stock on what they know (or think they know) based on personal experience. Overconfidence often leads to poor financial decisions, such as placing a majority of 401(k) assets in company stock. The reality is that diversification matters. A common recommendation of financial advisors is not placing more than 10% of assets in company stock and balancing company stock purchases with investments in other industry sectors.