3 Big Investing Mistakes

You frequently hear that “stocks always outperform over the long run.” But their potential depends enormously on the price you pay for them.

Stocks outperformed other assets in the past because they were cheap compared to their future dividends. But once the Dow had risen from 1,000 to 10,000, as it did from 1982 to 1999, this was no longer true.

What’s more, long-term return figures are suspect. Although Wharton’s Jeremy Siegel has argued that shares have beaten inflation pretty consistently by about 7 percent a year, on average, economists such as Elroy Dimson, Paul Marsh, and Mike Staunton at the London Business School, have found that the typical annual return was more like 5 percent over inflation. This means there’s a much greater chance that you will actually lose money over 10 or even 20 years.

Keep in mind: Stocks aren’t simply volatile. They tend to be volatile at exactly the wrong times — namely, when the economy plunges into turmoil, people lose their jobs, and they need their savings. This is exactly what happened during the crash of 2007 to 2008. Stocks for the long run became stocks for a long face.

Diversification doesn’t always work, as many investors learned in 2008. What went wrong?

For one thing, investors weren’t as diversified as they thought. If your mutual funds have to keep all their money in stocks and can only bet that shares will rise, you’re not diversified. You just have variations on the same investment.

For another: Modern portfolio theory says investors should own lots of different assets that are uncorrelated (to get better returns with less volatility). But in the age of globalization, asset classes have become like teenagers on prom night. It’s getting tough to keep them apart.

The one thing that goes up in a crash is the degree of correlation. Different assets may rise differently, but the crunch comes, they all fall together. So diversification helps you least just when you need it most.

Finally, the diversification theory only works if some assets are cheap while others are expensive. If you have a worldwide bubble and all shares go through the roof at the same time, the diversified investor just ends up holding a broad basket of overpriced assets. And that offers no protection.

Many people believe they can easily earn higher returns by taking on more risk and volatility. They’re often encouraged in this belief by the finance industry. There are two problems with this idea.

For one thing, you don’t know how much volatility you can handle until you’ve been through it. For another, taking on more risk may not even earn you higher returns.

Although dynamic, fast-growing stocks are often described as “riskier” investments that will produce higher returns with more volatility, over many decades they have usually produced lower returns than baskets of duller stocks that enjoy high company profits and pay big dividends. That’s because most of the time, the growth stocks have been overvalued.

From Storm Proof Your Money by Brett Arends. Copyright ©2010 by Brett Arends. Reprinted by permission of John Wiley & Sons, Inc.

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