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5 Dumbest Statements in Investing

I've been around the block a time or two, and over the years I have heard many of the dumbest statements ever made about investing. They all have one thing in common, two things if you count that they are wrong - they were made by "experts" who sincerely believed they were correct. Here are some of my favorites along with why you should never fall for them.

Read each one and figure out why it's so dumb. Then turn the page for my explanation.

# 1: You are overly diversified

# 1: You are overly diversified - This may be my all-time personal favorite. Why diversify when you can just pick a few star stocks such as Borders, Lehman Brothers, and Enron? I agree that investors can sometimes have too many mutual funds in their portfolios, such as the client that came to me after the tech bubble with 10 different Janus mutual funds that all were heavily weighted in tech stocks.

But if you're doing it right, investing is about only taking risk as compensation for higher expected return. Less diversification ultimately means you are taking on risk without compensation. This is speculation, also known as gambling. Owning a couple of broad stock index funds, like Vanguard's Total Stock (VTI) and Total International Stock (VXUS,) provides all the stock diversification you need, yet certainly isn't overly diversified.

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#2: You can build wealth without risk

#2: You can build wealth without risk - As the infomercials go, you insure your house, so why not insure your portfolio? You can earn a guaranteed eight percent compounded minimum annual return. While regulators allow this deception, common sense tells us otherwise. Fairy tales don't exist.

If such products really existed, banks and other financial institutions would be putting their money in them as well. And though insurance agents are quick to point out that these products are only for individuals, I have enough confidence in Wall Street and the insurance industry that they could design a product institutions could buy. But there I go again, using that pesky common sense to analyze the trickery of an industry where common sense isn't all that common.

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#3: The stock market has to go (up / down) because...

#3: The stock market has to go (up / down) because... - There are many variations of these statements and they are made by individual investors and experts alike. When markets tanked and bottomed out on March 9, 2009, the experts predicted the great depression ahead and gave all the reasons markets would continue to tank. Gary Schilling, the one expert who correctly predicted the 2008 market collapse, got 2009 and 2010 just as wrong.

Other variations of these comments include the Wells Fargo Chief economist who stated interest rates would definitely rise this year and that it was just a matter of how much. So far, even with the US flirting with default, he has been dead wrong as the five year T-bond rate has fallen from 1.95% to 0.91%.

Not only does the market not "have to" do anything, it tends to make fools out of those who don't know any better. In fact, very few people actually know we don't know why the market does what it does on any given day. Most buy into the media's daily explanation in order to believe they are making sense out of short-term randomness.

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#4: Indexing works in an up market but not in a down or flat environment

#4: Indexing works in an up market but not in a down or flat environment - The saying goes something like "A rising market floats all boats and indexing works well. Today, we have a stock pickers market as the bull rally is over."

This may be the dumbest of the dumb statements on this list. Believing it requires you to also disbelieve simple arithmetic. Let's compare a low cost Total US stock index fund, with a 0.07 percent annual cost, to an average cost portfolio or mutual fund with a two percent annual cost, in a bull, bear, and flat market.

By definition, the active portfolio will, on average, earn the market return before costs. Though you may do well by hiring one expert to outsmart another expert, you are just as likely to hire an expert that did poorly. As you can see, irrespective of the market performance, indexing beats active by its cost differential - 1.93%. It's not dependent upon which way the market moves, it's only dependent upon simple arithmetic. To believe otherwise is, well, dumb.

#5 Emerging market stocks will do best since that's where the most economic global growth will come from

#5 Emerging market stocks will do best since that's where the most economic global growth will come from - With the US and Europe in a debt crisis and stumbling, this statement on its face seems to make sense. That is, at least until you stop to think about it. Who doesn't know that the economies in China, India, and Brazil will be growing faster than the US economy? If it's a secret, it's a poorly kept one.

Beating the market, if such a thing were possible, would come down to knowing something the rest of the world doesn't already know. Jason Zweig once wrote a great Wall Street Journal piece noting that there was actually a slightly negative relationship between a country's economic growth and the performance of their stock market. That's because the higher growth is already priced into their stocks.

The phenomenon is no different than the fact that hot growth stocks tend, on average, to underperform beaten up dog value stocks. Expectations are high for growth companies like Netflix and low for value companies like Chevron. It's difficult for growth companies or growth countries to live up to the high expectations investors have priced into them.

Turn the page to see the lessons from these dumb statements.

My take
The stock market makes fools out of nearly everyone that presumes to understand it. Even so-called experts with long track records, like Legg Mason's Bill Miller, who, after his horrible performance in 2008, claimed it was a once in a century event.

All five of these dumb statements have their roots in arrogance and ignorance. They are made by people too arrogant to understand that investing isn't really all that easy, and too ignorant to know that they didn't know how to beat the market and get high returns with little risk.

It turns out that common sense isn't so common.

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