Investing

Click here for the first five market myths you shouldn’t believe

Hindsight in investing is a wonderful thing. If we knew everything after the fact then we’d probably be more questioning of some of the folklore surrounding financial markets. We look at five more market truisms, most of which would be better described as market myths.

Myth No. 6: TREASURIES

You never lose money in government bonds

Investors only have to look to the threat of a US sovereign debt default to realise just how unsafe government bonds have become.

“Governments around the world spent billions on bailing out banks and stimulating their economies, and as a result have run up huge public-sector debt,” Australian Stock Report research analyst Benny Sada says.

“Investors are coming to realise that governments are unlikely to pay off their debt without harsh spending cuts and/or tax hikes – two remedies likely to debilitate an already weakened economy.”

The result is a question mark on the will and ability of governments to fulfil their debt obligations.

The market response has been a massive spike in the bond yields of the highly indebted nations such as Greece and Portugal.

As long as investors hold onto the bonds until maturity they won’t lose money. But higher yields mean people who sell before maturity will lose part of their capital.

The head of portfolio management in the bond team at Tyndall, Anita Daum, says not all government bonds are highly rated; several European Union government bonds were downgraded in recent months. The US has been placed under review and may lose its AAA rating.

Daum says Australian commonwealth government bonds are an exception – they are in demand given the relatively low level of government debt and AAA rating. What is worse than a downgrade is when a government defaults and can’t pay its debt obligations.

MYTH NO. 7: DIVERSIFY

Diversify to minimise losses

The saying “don’t put all your eggs in one basket” is a favourite in investment circles. While that makes sense, diversifying for the sake of it does not. What we saw in the GFC was that there are times when everything goes down at once.

“The standard argument is that investors should diversify to minimise risk but it is a mistake to believe that you reduce your risk by buying a small range of stocks that you know nothing about,” says independent value investor Roger Montgomery.

“If you don’t know what you are doing and you are just spreading your money around you are not necessarily reducing your risk of loss.”

The key to diversification in a portfolio is the correlation of the stocks you purchase. Just by having two stocks in completely different sectors can help reduce risk.

Montgomery says the benefits of diversification can be significant when there are between 12 and 22 stocks.

Beyond about 20 stocks the incremental benefit is less than the cost and time associated with managing those extra stocks.

D’Amato says investing across a range of asset classes is another popular way of reducing risk.

Doing this can help to make any earnings more predictable and smooth out the investment stream going forward, he says.

MYTH NO. 8: Cash management trusts

Cash management trusts are safe and liquid

No investment is totally safe and cash management trusts are no exception. A CMT is just like any managed fund that pools investors’ money. Depending on the stated objective of the trust it will generally place money into cash or cash-equivalent investments such as short-term money market securities, including floating rate notes.

There is no guaranteed rate of return. It depends on the underlying investments and the fee being charged by the managers. Higher-yielding cash management trusts may indicate the money is being invested in riskier underlying assets.

In all cases there are market, credit and operational risks. The overall risk of a CMT can be gauged by the credit rating applied by ratings agencies. While most CMTs make your money available within 24 hours, it depends on the circumstances as to whether this would always be the case.

During the GFC investors in several CMTs rushed to remove their money and redirect it into higher-yielding, government-guaranteed deposits. In some cases investors had to wait several days to receive their cash because of the flood of redemptions.

Daum says the important thing to note about CMTs is they are not all the same. As well as having different structures they will invest in different investments within those structures. “Some cash trusts invest in longer-dated credit securities, which can reduce liquidity in times of market disruption and could cause losses in the fund if they needed to be sold during that period,” Daum says.

She says cash trusts mainly invest in bank securities so if there were to be a default by any of the banks whose securities are held in the trust, it is likely losses will be incurred. Generally some of the cash trusts’ investments rank behind deposit holders in the event of default, she says.

MYTH NO. 9: REBOUNDS

Last year’s losers are next year’s winners

If only it were that easy. In the case of asset classes, if you were to follow this theory then in 2001, after returning just 2.2 per cent in 2000, you would have gone for international shares in the expectation they were going to outshine other asset classes.

Over the following three years they lost 10.1 per cent, 27.4 per cent and 0.8 per cent. They did rise 9.9 per cent in 2004 but then Australian equities rose 27.9 per cent after being the best performer in 2003.

The worst-performing asset class in 2008 was listed property with a 55.3 per cent loss. If you were to put your money there you would have picked up the 9.6 per cent gain the following year but missed out on the 37.6 per cent rise from Australian shares. With individual stocks, it has to come down to the company.

Last year’s dog performers won’t always be next year’s darling but they are a great place to be looking for opportunity if the investment thesis stacks up, Loxton says.

“Some companies can have a few years in the doldrums; some just don’t recover,” he says. “They may have been marked down for a very good reason.”

Lincoln chief executive Elio D’Amato says it is better to put money into underperformers than underperforming companies. You should also consider the opportunity cost before you buy.

“You can put money in a fundamentally sound business that has been knocked around in the hope that it will turn around,” he says. “Or you can put money in a company that can work for you.”

MYTH NO. 10: PATIENCE

Hang on, don’t sell now, they’ll come good

“Time is a friend of an extraordinary business but the enemy of a mediocre one,” Montgomery says.

The idea of not selling now because it may come good fails to recognise the fact the shares you own are not like the red and black diamonds on a roulette wheel, he says. The probability that the share price will come good depends entirely on the performance of the business.

“It is not true that if you hang it will eventually come good,” he says.

D’Amato says many investors think that the hardest part is selling a stock. “Well it is a lot harder to buy a stock back for more than you sold it for,” he says.

D’Amato says the less confident you are of a business then the tighter the stop losses should be.

“We never know where the bottom is but we sure know when we miss it,” he says.

Intelligent Investor analyst Nathan Bell says investors are psychologically wired to hanging onto losers in a portfolio.

“If the initial idea behind why you bought it is still there and it looks cheap then hang onto it,” he says. “But if the idea has changed then sell it and follow your best ideas.”

Bell adds that investors should always focus on the business and ignore the broader market to a certain extent.

“Look at the business first and then look at the price on the stockmarket to see if it is worth holding or buying more of,” he says.