One of the benefits of living in the digital age is that we have access to more information than ever before. Unfortunately, this also means that we have access to more disinformation than ever before. There are a lot of plain wrong investing beliefs out there that lead investors astray. Here are three that you should learn to identify and avoid.
“You have to take on higher risk for higher returns”
It’s a commonly-held belief that if an investor wants to earn higher returns, then they have to purchase riskier investments. The logic behind this belief it is that all stocks are priced fairly, and that their price reflects both the potential upside, and the potential downside of a stock. So in this scenario, the only way to get a return of, say, 10%, is to buy a stock with an equally high chance of losing 10%.
I believe that this is wrong. Good returns are not achieved through buying the most volatile stocks in the market, they are achieved by looking for opportunities where the upside is greater than the downside. If you can identify a stock where there’s a 50% chance of it doubling your money, and a 50% chance of it losing 20% of its value, then that is a good investment, even though the two probabilities are the same.
How does one go about identifying such opportunities? By finding stocks that are trading at low prices relative to their actual value. You can do this by looking at metrics like price-to-earnings, or price-to-book value, and looking for companies that are trading below the industry average.
“Good investors have to time the market”
Not only do the best investors not do this, I believe that it is impossible to do so with any consistent success. If you look at the record of economic forecasters, it’s a pretty shoddy thing — and even the people who are singled out by the media as ‘experts’ usually only have one or two lucky calls that went their way.
Moreover, contrary to popular opinion, the best traders don’t time the market either — they base their decisions on what is happening in the present, not what they think will happen in the future. In short, successful capital allocators don’t try to predict the future, they simply look at what is undervalued in the here and now, and base their decisions on that.
“The only good decisions are those that make money”
Too often people will point to strategies that have made money recently and declare them effective. In truth, a good process can yield poor short-term results, just as a bad process can be successful in the short-term. You can get pretty far by buying expensive stocks in a bull market and hoping that they become more expensive. However, anyone following such a strategy will inevitably lose when the market turns — and as we have established, this is impossible to forecast. A good investing strategy doesn’t just make money in the good times; it’s one that doesn’t lose money in the bad times either.
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Neither Stepan nor The Motley Fool UK have a position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.