The investment world is full of analysts, financial advisers and investor friends who want to tell you what you should do with your money.
Most of the time, their advice is well-meaning.
You might even agree with them – recalling how you saw the same advice on CNBC, reading The Economist or having heard 20 of your friends espousing the same sagely investment strategies.
I like to tell readers of my articles to critically think through and process what they’ve read or heard…
…because even the most reputed advice or research can fool you.
In this article, I want to highlight some of the pitfalls of some of the most common investment advice out there. By doing so, I hope you’ll start to ask more questions if that advice is suitable for you – and make better informed decisions.
Note – this isn’t a “debunking” investment myths post…
Rather, these advice may be legit, but might just require you to think deeper if it will work specifically for you.
Let’s get to it.
#1: “If you’re lazy, just invest in the STI ETF (or any major market ETF) can already”
Sure, Warren Buffett once said that a 90%/10% Vanguard S&P 500 index fund and Treasury allocation would make the cut for most investors.
It is found that over the long run, most active investors failed to beat the market – and so ETFs have become a logical choice.
That’s a no-brainer, right?
It’s waaayyyy higher than 1% on Fixed Deposits or the 4-5% keeping it in your CPF Special Account.
Sorry, but you might be disappointed.
First off, the returns you get from investing in the market ETF is still going to be dependent on the price that you entered.
Take a look at my chart below.
Secondly, even if you “heng heng” had the courage to buy at the bottom of the 2009 global financial crisis, the 9.2% annualized returns are only possible if you had reinvested ALL the dividends back into the ETF.
Thus, this outcome would be quite unlikely – given the fact that we Singaporeans like to receive our dividends in cold hard cash and not “more ETF units”…
Even if you did monthly dollar-cost averaging (DCA) and bought small chunks of the ETF ($1000 per month), you’d have averaged a $2.49 cost.
Assuming this is being done for the last 10 years (because that’s how far my data can go! Sorry!), you’d only get an annualized return of 3.16% (excluding dividends) and around 6.66% per year (including dividends, assuming an average 3.5% dividend yield).
Sorry – nowhere close to the 9.2% you’d expect!
If you think an ETF on the US S&P 500 is better, this calculator by Moneychimp shows otherwise too!
This brings me to my final point – frictions.
You’d have seen me write about frictions in my previous article. Frictions are things like brokerage fees, tracking errors, expense ratios, slippage (your orders getting filled above the price you want to buy at due to illiquidity), or even simply failing to buy at consistent times if you’re DCA-ing.
All these frictions can add up (especially if you’re DCA-ing) and compound over time – which could very well eat into your average returns.
Takeaway: Don’t get me wrong. ETFs are still a very prudent and sound way to invest and beat inflation. However, before you expect it to deliver outstanding returns, consider these issues first and manage your expectations!
#2: “Make sure you can beat the market. If not, don’t pick stocks!”
This is somewhat similar to #1, except I want to talk about this point on its own.
Like I mentioned earlier, much of the word on the street is that most (American) portfolios don’t beat the S&P 500 index.
But why compare yourself with the S&P 500? Or the Straits Times Index for that matter?
There’s something known as the benchmark error – which many investors fall prey to.
This is when you build a portfolio and actively compare it to the performance of the S&P 500…
…even though your portfolio might largely consist undervalued stocks, or technology stocks or small-cap stocks.
If you feel the need to benchmark, you should select an appropriate benchmark that contains similar risk and return characteristics to your own portfolio.
For instance, you’d compare a portfolio concentrated on tech stocks to the NASDAQ composite index, and not the S&P 500.
You’d compare your small-cap Singapore portfolio with the FTSE ST Small Cap Index… instead of the Straits Times Index.
And you’d compare your undervalued Asian stocks portfolio with the FTSE Value-Stocks ASEAN index… instead of the Straits Times Index or Hang Seng Index.
Ideally (in my opinion), investors should not even use a benchmark.
It makes investors feel pressured to outperform, and leads them to make risky bets that would be way out of their comfort zone.
Chasing returns is just one part of the equation. You also need to make sure you can manage the downside risks.
If you were to match the market, the drawdown (maximum decline in prices) could go 40% and even 50% below what you originally bought at.
Theoretically, if you manage to have higher returns than the market, you’d have a much bigger drawdown.
Can you afford to take that kind of risk? Be honest!
Finally, another reason why you shouldn’t compare to an index is simply…
…you have very little in common with an index!
The folks at Real Investment Advice put up a really interesting piece on this.
Here’s the difference between you and an index:
- You are subject to “frictions”, the index doesn’t
- The index contains no cash
- An index has no life expectancy requirements – but you do.
- It doesn’t have to compensate for distributions to meet living requirements – but you do.
- It requires you to take on excess risk (potential for loss) in order to obtain equivalent performance – this is fine on the way up, but not on the way down.
- It has no taxes, costs or other expenses associated with it – but you do.
- It has the ability to substitute at no penalty – but you don’t.
- It benefits from share buybacks (market capitalization) – but you don’t.
Takeaway: Don’t compare to a benchmark if possible. If you really have to, choose an appropriate one – and not just brush it over with S&P 500 or the STI.
#3: “Diversification is Important!”
This is good advice for investors who don’t want to do their own individual stock research.
For concentrated-portfolio stock pickers, Warren Buffett gives some straightforward advice,
“Diversification is protection against ignorance. It makes little sense if you know what you are doing.”
There’s also this thing called “diworsification” – which was coined by famous fund manager Peter Lynch.
It’s when you diversify too much or “diversify for the sake of diversifying” that you lose the marginal benefit of reducing your total risk as more stocks get added into the portfolio.
Most investors don’t diversify their stocks effectively. The “conventional” way most advisers or fellow investors would ask you to diversify is:
- Across different industries (healthcare, food and beverage, technology)
- Across different geographies (China, US, Singapore)
- Across asset classes (stocks, bonds, real estate, gold)
This is very sound advice… theoretically.
However, things often don’t work as you’d expect it to.
Real Investment Advice shows in another article where studies found “the failure of diversification during the [2008 financial] crisis”…
…as stocks and bonds both went down in prices.
Theoretically, bond prices were supposed to rise – due to the inverse relationship with stocks.
They suggested that shocks to interest rates and inflation can turn correlations of these asset classes positive – and that investors who thought they were well diversified were “surprised” when their portfolios were heavily affected by the market downturn.
Interestingly, they also noted that investors were increasingly seeking “new or specialized sources of diversification”.
This is also one of the reasons why factor investing has risen in popularity over the recent years – because of the supposed newly-discovered diversification benefits across multiple “factors”, as compared to the traditional ways.
Same advice I’m going to give you – manage your expectations.
Takeaway: Diversification is a sound investment strategy – no doubt. But don’t put all your eggs in that basket (pun intended)… Make sure you know what you’re doing!
And, in my opinion – a concentrated portfolio is probably the way to if you want market-beating returns. But that’s only if (and only if) you have a good tolerance for risk (ie. young investor) and, once again, know what you are doing!
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Equity investment analyst at Dr Wealth. Value investor and online marketer.