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Thursday, September 12, 2013

4 investment tips that you should never use


Sept. 11, 2013, 6:16 a.m. EDT      By Paul Merriman

Saving for retirement is hard enough, but some common, everyday investment advice can get new investors off to a bad start, or worse, create losses for long-time savers that they’ll never make up.

You probably know better than to fall into these traps but I can just about guarantee that at least one person you know has believed — and acted on — some of the world's worst investment advice.

As Warren Buffett says: "You only have to do a very few things right in your life so long as you don't do too many things wrong." And to that I would add: Most things we do wrong start because we acted on bad advice.

Let's look at four bits of common — and terrible — advice:

No. 1: "The best investment you can make is in well-run growth companies."

This sure sounds enticing. Who wouldn't want to own high-quality companies that are managed well and highly respected?

If your highest priority is the comfort of knowing you own popular companies, this isn't awful advice. But if you want superior long-term returns, you should know that value companies and small-cap companies have a higher probability of giving you those gains. The reason is simple: High-quality growth companies are popular and fully priced. Almost by definition, you can't buy them at bargain prices.

(I want to emphasize here that several of these examples are aimed at investing in individual stocks, which for most nonprofessionals is among the worst investment moves. As I have written and said more times than I can count, smart investors own hundreds or even thousands of stocks through diversified mutual funds.)

It's no secret that value stocks and small-cap stocks have higher long-term expected returns than large-cap growth stocks. Academics remind us, accurately, that those higher returns come from taking additional risks. However, value companies and small-cap companies, as asset classes, have achieved their higher returns with only modest amounts of additional risk.

No. 2: "The longer you hold an investment, the higher your probability of success."

That seems plausible on the surface, but in fact it is wrong. In fact, the opposite is true. The longer you hold any company or a diversified portfolio, the higher the probability of a catastrophic event. An economic meltdown isn't very likely in the next year or two but is much more likely sometime in the next 50 years.

Wall Street is littered with the failed dreams of investors who wouldn't give up or throw in the towel even after decades of waiting for their investment choices to be vindicated.

This is less true when it is applied to the whole market or to an asset class such as large-cap growth stocks. In the next 12 months, relatively few companies will run into severe problems (aside from what happens to the whole economy). But 25 years from now, many of today's well-known and highly regarded companies will be gone.

Yet in 25 years from now, a few companies will have outstanding long-term records of never (or almost never) reporting flat earnings or failing to raise their dividends. And in 25 years from now, in the year 2038, many investment advisers and pundits will focus on those few long-term survivors to "prove" the value of long-term patience in individual stocks.

In 2038, the investment industry will pay little attention to the much larger number of companies that look good today but which will fall by the wayside in one way or another. After somebody wins the lottery, you'll typically see a photograph or a video of one couple holding the big check. I have never seen a picture of the millions of lottery players who were the losers.

No. 3: "Cut your losses and let your profits run."

Perhaps this makes sense if you are buying and selling individual stocks. But if you're investing for the long term in asset classes with long histories of productive returns, this is awful advice.

Every asset class inevitably has its ups and downs. Investors who aren't willing and able to hang on through down cycles will never achieve the long-term rewards that they seek. Virtually all the academic evidence shows that among asset classes, short-term winners will someday become short-term losers, and vice versa.

You can use this to your advantage if you turn the conventional advice upside down. Do that in two parts. First, periodically take some profits from your most productive asset classes. Second, use the proceeds to invest in the asset classes that have been underperforming. This forces you to take some of your profits before the market takes them away.

No. 4: "Invest in companies you know and whose business you understand."

Many times over the years I've heard that "pearl of wisdom," which is supposed to help investors pick stocks. It might be good advice if your objective is to feel comfortable and smart. But it's lousy advice if you want good long-term returns. I'll tell you two pretty obvious reasons that this is crummy advice.

First, many of us know a fair amount about a single industry. But this doesn't tell us anything about where future profits will come from. If I invest only in the industry with which I happen to be familiar, I won't have adequate diversification. And I'll undoubtedly miss out on many great opportunities, just because I don't understand them.

Second, there's a huge difference between what we think we know and what we actually know. I've seen time and again how some really smart investors become convinced that they "know" a particular company or an industry is a sure thing, only to see their investments nose dive.

I have a friend who invested almost all his retirement savings in the stock of Washington Mutual, based on his knowledge of the industry and of that company. His dogged belief cost him most of his nest egg, and he will never achieve the lifestyle that could have been his if he diversified.

Though this advice is very tempting, too often it's a road map to financial disaster.

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