The Little Book of Market Myths

1. Question Everything: The Path to Investing Success

Questioning yourself is hard.

Challenge your assumptions. Investors often make mistakes because they think they're making smart decisions based on common knowledge or advice from seemingly knowledgeable sources. However, the most successful investors constantly question their beliefs and assumptions. This practice helps avoid costly errors and can lead to discovering profitable opportunities that others miss.

Overcome evolutionary instincts. Our brains evolved to avoid humiliation and pain, which can hinder effective investing. By questioning ourselves, we risk discovering we're wrong, which can be uncomfortable. However, this discomfort is far outweighed by the potential benefits of making better investment decisions.

Develop a questioning mindset:

• Ask "why?" about every investing decision you make
• Investigate claims that "everyone knows" to be true
• Look for data and evidence to support or refute your beliefs
• Be open to changing your mind when presented with new information

2. Volatility is Normal and Necessary for Long-Term Returns

You can't get the upside without the downside.

Embrace volatility. Many investors fear market volatility, but it's a natural and necessary component of investing. Without volatility, there would be no opportunity for higher returns. Understanding this concept can help investors stay the course during turbulent times and avoid making emotional decisions that harm long-term performance.

Long-term perspective matters. While stocks are more volatile than bonds in the short term, this relationship changes over longer periods. Over 20-30 year periods, stocks have historically shown lower volatility than bonds while providing superior returns. This highlights the importance of maintaining a long-term investment horizon.

Key points about volatility:

• Stocks are positive in 72% of all calendar years
• Short-term volatility often feels more intense than it actually is due to our evolutionary biases
• Attempting to time the market based on short-term volatility is likely to harm returns
• A well-diversified portfolio can help manage volatility while capturing long-term growth

3. Asset Allocation: The Most Critical Investment Decision

The critical asset allocation decision is the most critical one investors make.

Understand the impact. Asset allocation—the mix of stocks, bonds, and other securities in your portfolio—is responsible for approximately 70% of your long-term investment performance. This far outweighs the importance of individual security selection or market timing.

Avoid simplistic rules. Many investors rely on overly simplistic asset allocation rules, such as subtracting your age from 100 to determine your stock allocation. These one-size-fits-all approaches ignore critical factors like individual goals, risk tolerance, and time horizon.

Factors to consider in asset allocation:

• Investment time horizon (often longer than most people think)
• Cash flow needs (both current and future)
• Risk tolerance and capacity
• Overall financial situation and goals
• Inflation expectations
• Current market conditions and valuations

4. The Myth of "Capital Preservation and Growth" as a Unified Goal

You simply cannot have capital preservation and growth at the same time.

Understand the trade-off. Many investors are attracted to strategies promising both capital preservation and growth. However, these goals are fundamentally at odds with each other. True capital preservation requires eliminating volatility risk, which also eliminates the potential for meaningful growth.

Align goals with time horizon. For investors with long time horizons, focusing solely on capital preservation can be detrimental to achieving long-term objectives. While short-term volatility may be uncomfortable, it's necessary for achieving the growth required to meet long-term goals.

Considerations for balancing preservation and growth:

• Assess your true time horizon (often longer than initially thought)
• Understand the impact of inflation on purchasing power over time
• Consider a diversified approach that balances stability and growth potential
• Regularly review and adjust your strategy as circumstances change

5. Economic Indicators: Unemployment Lags, Stocks Lead

Unemployment is now, always has been and always will be a lagging indicator.

Understand indicator relationships. Many investors and policymakers mistakenly believe that high unemployment causes economic weakness and poor stock market performance. In reality, unemployment is a lagging indicator, reflecting past economic conditions rather than predicting future trends.

Look to leading indicators. The stock market itself is a leading indicator for the economy. Investors typically bid up stock prices in anticipation of economic recovery, well before improvements show up in lagging indicators like unemployment.

Key points about economic indicators:

• Recessions typically start when unemployment is at or near cyclical lows
• Stock returns are often strongest when unemployment is high and rising
• Consumer spending is remarkably stable, even during recessions
• Business investment is more volatile and influential on economic growth than consumer spending

6. Debt Levels: Context and Affordability Matter More Than Size

The issue isn't debt, but whether that debt is affordable.

Challenge debt assumptions. Many people believe that high levels of government debt are inherently bad and will lead to economic ruin. However, the absolute level of debt is less important than its affordability and the overall economic context.

Focus on affordability. Despite higher absolute debt levels, the United States currently has historically low debt servicing costs due to low interest rates. This makes the current debt burden more manageable than in many past periods with lower absolute debt levels.

Key considerations for assessing debt:

• Debt as a percentage of GDP, rather than absolute numbers
• Interest payments as a percentage of GDP or government revenue
• The country's economic growth potential and productivity
• Global demand for the country's debt (e.g., US Treasuries)
• Historical context and comparisons to other developed nations

7. Market Resilience: Stocks Can Rise Despite Global Turmoil

History is never pristine. The world can be a pretty darn scary place—there's never a dull moment.

Recognize market resilience. Throughout history, the stock market has faced countless challenges, including wars, natural disasters, political crises, and economic turmoil. Despite these events, stocks have shown remarkable resilience and have generally trended upward over the long term.

Avoid waiting for calm. Investors who wait for a "calm" period to invest often miss out on significant returns. There is always something to worry about, and well-known concerns are typically already priced into the market.

Examples of market resilience:

• Stocks rose during much of the Cold War, despite nuclear tensions
• Markets recovered quickly after the 9/11 terrorist attacks
• Global stocks have performed well despite ongoing geopolitical tensions and natural disasters
• Technological innovation and economic growth have persisted through various crises

8. Media Interpretation: A Key to Gaining Investing Edge

If you read or hear about some investment idea or significant event more than once in the media, it won't work.

Use news as a contrarian indicator. Widely reported news is typically already reflected in stock prices. Instead of reacting to headlines, use media coverage to understand what the market is focusing on and look for opportunities in areas receiving less attention.

Develop a different perspective. Learning to interpret news differently from the crowd can provide a significant edge in investing. This involves looking beyond the immediate sentiment reaction and considering the broader context and potential long-term implications.

Strategies for better media interpretation:

• Look for underreported stories or trends
• Consider how widely held beliefs might be wrong
• Analyze the potential market impact of news, not just the news itself
• Use media coverage as a gauge of investor sentiment
• Seek out diverse sources of information and viewpoints

Last updated: November 19, 2024