Investing Myths - 2

Investing Myths....(Continued from the previous post)

Myth 4:
Asset Allocation is the key to investing success:

A big fat lie!

The investment community loves to push this idea. Allocate your money across various assets. Have a clear plan of how much of your money should go into equities, how much into debt, how much into real estate, how much into gold, etc.

The basic idea behind recommending an asset allocation plan is that when one asset class goes down, some other will go up. Also there would be an automatic rebalancing of portfolio, selling when an asset goes up and buying when it goes down. Buy low, sell high! How nice!

Except that is it far from nice!

Asset allocation is good if two conditions are satisfied:
1.) The assets have no co-relation or are negatively co-related with one another. i.e. the movement in one asset is independant of the movement of the other asset (un-corelated) or if one asset moves up, the other moves down (negatively co-related).

But in real life, stocks and bonds (paper assets) are positively corelated. Gold and stocks might be negatively corelated. Even this relationship breaks down at times. Over the last 5 years, all assets have gone up, stocks, bonds, real estate, commodities, art, etc. Sometimes all assets go up together, sometimes all come down together.

2.) The assets offer more or less, equal return prospects over time. If we assume that bonds will give lower returns than stocks, creating an asset allocation between bonds and stocks will lower overall returns (but also offer lower volatility).

Asset allocation, the way the investment community preaches, lowers portfolio volatility but also lowers returns. I had written a post earlier demonstrating the returns from one particular asset allocation method. The link is: http://shashankjogi.blogspot.com/2008/07/comparing-5-investing-strategies.html

There is no substitute to ability.


Myth 5:
Now that the market is down, it’s especially attractive and you should buy all you can and just hold it.

Being down does not equal attractive. Markets move from extremes of optimism and pessimism. Hence valuations move from seriously overvalued to seriously undervalued on and off. When prices fall, even 30-50%, it does not automatically make stocks attractive. If you are a value investor, you should buy when stocks are cheap, regardless of the extent of rise or fall in a stock.

Again, the investment community loves to give Warren Buffet's example. If Warren Buffett holds on through 50% drops, because then things really are a bargain, then you should do so as well.

In reality, Warren Buffet buys stocks when they are quoting at 50 paise to the rupee. Most of us do not have the capability that he possesses. We get misled by expensive stocks masquerading around as value stocks. We do not have an understanding as deep as Buffet has about most businesses. So we tend to pay Rs 2 for a stock worth Re.1, thinking that we are paying Rs.2 for something worth Rs.4.

How many people bought stocks into the first crash in January 2008? Many did and now they are stuck. We saw a period between 2000 and 2003 when stock prices went down 50%. After each 10% fall, stocks looked better but kept going down. So many highflying stocks on the tech bubble have vanished now.

The bottomline is:
-There is a time to buy and there is a time to sell.
-There is an environment when stocks do well and there is an environment when stocks do poorly.
-Stocks go down for good reasons.
-Understand the reasons, evaluate if there is merit and then buy. Not just because stocks are down.


Myth 6:
Stocks are an excellent hedge against inflation

Yes, but only if...

Have you heard how stocks give returns much higher than inflation, while with Fixed Deposits and bonds, inflation makes real returns tiny? So the Sensex has given an 18% compounded return over the last 29 years while inflation has been 8% on an average. Doesn't it show the power of equity investing in trumping inflation?

But why did stocks not beat inflation in the period 1992-2003? The sensex gave a negative 3% return compounded. Stocks not only lost money in nominal terms, it also lost more money in real terms. Stock market investing over this period impoverished investors, in general.

Stocks do well in a low and stable inflationary and low and stable interest rate environment. Both, high inflation and deflation are bad for stocks. If you recall, the mid to late 1990s was a period of high inflation 8-10% and rising interest rates. The period between 2000-2003 was a period of a global recession and a slowdown in the Indian economy. We then saw a period of low inflation (4-6%) and low interest rates between 2003-2007 which was one reason among many that fuelled the bull market in stocks.

Over the last 30 years, favourable conditions on a general basis ensured that stocks do well. Who is to say how the future will be like? Will it be like the 1970s where inflation was high and interest rates were ratched up? Or will calmer times return. The answer to this question will determine whether stocks are able to beat inflation by a whopping margin. A blanket statement saying that stocks are good against inflation is assuming such good times will remain.



I have merely highlighted a few myths that are commonly held. There are many more. A wise investor will always look for reason and evidence in any such statements before accepting such assertions.