There are strange myths and half-truths floating around in the public consciousness regarding the world of investing, which every beginner (and non-beginner) investor encounters in various writings. Below, I have gathered a few such examples.
The wider the diversification, the better
Well, diversifying our portfolio is extremely useful; it reduces the risk of our investment decisions, so an occasional (and hopefully minimal) bad decision will cause us less financial and emotional pain. At the same time, it is important to highlight that diversification is only useful up to a certain point. Research has shown that for portfolios larger than roughly 30 stocks, the benefit of broad diversification disappears—it does not significantly reduce risk, while tracking this many companies consumes valuable energy and attention. It is worth buying shares in fewer companies whose operations we know better and whose industry environment we understand more, allowing the risk reduction otherwise provided by diversification to be realized through our business knowledge.
Bonds are a good investment
This statement, on its own, no longer holds up. Over the long term, stocks significantly outperform bonds, and the volatility of long-term government bonds, for instance, is barely lower than that of stocks for most of the time—in exchange for much lower returns. Of course, there may be years when they outperform stocks, but on its own, if we think long-term and want to grow our wealth, it is not worth paying much attention to bonds. At most, short-term bonds are worth holding as an emergency reserve or until a good buying opportunity arises in the stock market. Furthermore, bonds fail to beat inflation most of the time, providing yet another reason to invest our money in stocks.
The classic 60/40 portfolio
This means putting 60% of our portfolio into stocks and the remaining 40% into bonds, thus splitting the difference between higher growth and the stability of our portfolio’s value. Reflecting on the previous point, it is not worth holding 40% in bonds; as large a portion of our portfolio as possible should consist of stocks.
Regular rebalancing
Sticking with the 60/40 example, there are expert opinions suggesting that we must regularly rebalance our portfolio back to its initial proportions, as certain assets in our portfolio may grow faster and thus represent a larger share of our total investment. We would reset the proportions at fixed intervals. This makes little sense: if we own an extremely high-performing, valuable company, why would we part with its stock simply because our other assets performed worse? Would we really get rid of the best piece of our portfolio to swap it for underperforming stocks? The financial world invents interesting theories, sometimes contrary to long-term business logic.
Buying the trend
A common behavior among speculators on the stock market is buying a stock when its price is rising, believing it is a sure buy and that they will be able to exit at the right time to lock in a nice capital gain. Buying a stake in a company simply because its shares have become more expensive on the exchange is an utterly absurd and mistaken idea. You can look at stock prices, but on their own, they are worthless. We should buy a stake in a company because we want to become its owners and share in its business results over the long term. In such cases, the direction of momentary price movements is completely irrelevant; the true strength of our investment’s value will show over years.
Naturally, one could go on listing the common notions floating around in the public mind regarding financial topics. What is interesting is that often the simplest misconceptions—the ones that are transparent at first glance—are the ones that spread the most and cause misunderstandings and serious losses.