If you are thinking about investing, chances are you will come across advice and suggestions, which are often unsolicited. Some are common sense, such as do not time the market or past performance does not guarantee future returns and etc. Others vary on circumstances, but some are just straight-up myths not backed by credible sources.
Here, we will be busting 7 common investing myths and explain the reality backed with research:
- Myth #1: Investing is too risky
- Myth #2: You need to be knowledgeable about the market to invest
- Myth #3: Monitor your investments all the time
- Myth #4: Investing is for the rich
- Myth #5: You lose more money to the market
- Myth #6: Emotional investors take more risks
- Myth #7: Alternative investments are riskier and more illiquid than traditional investments
Myth #1: Investing is too risky
Reality: The general sentiment that "investments are risky" is true. Investments are volatile and rely a lot on speculation. It relies on both macroeconomic variables and investor's sentiment. Consequently, the market prices do not reflect all information regarding the investment asset. Investment, therefore, is risky and it should not be assumed otherwise.
However, investments should not be avoided altogether because of risks. Investments have the potential to grow your net worth and be financial comfortable. Granted, some assets are riskier than others (stocks for example), but that is the tradeoff that comes with high-return investments.
The reality of investments is that you can minimise risks. While many swear by the general strategies, such as, asset allocation, diversification and lowering costs for risk minimisation, studies have found on the contrary. There is no evidence to suggest that having a dedicated risk management executive lowers your risk. Rather, it's been proven in studies that investments that use formal models to analyse portfolio risk are more accurate in their expectations. Formal models of risk evaluation includes, Value at Risk, Stress testing and Scenario analysis.
Myth #2: You need to be knowledgeable about the market to invest
Reality: There is some truth to that statement - some knowledge is actually beneficial for investing. Multiple studies have found the correlation between financial knowledge and investment decisions. Moreover, while studies have shown that portfolio of more knowledgeable investors are more volatile, it also generated more returns due to its exposure. However, there are numerous other investment approaches that only demand a basic knowledge of market trends. Retirement accounts like Pillar 2 and 3 are an example. They are tax-advantaged accounts, which means you do not have to pay taxes on the interest until you withdraw them.
Myth #2.1: Too young to start investing
Reality: It is never too early to start investing and it is never to late. There are many obvious benefits to investing early many of which are intertwined. Stating early means there is more time to compound on your interests allowing your investments to grow stably.
Another more interesting reason to encourage investors to start early has to do with investment skills as you age. Young investors are more likely to make mistakes and opt for riskier assets enticed by higher returns. Older investors are more likely to be knowledgeable about investments, trade less, minimise risks, diversify more and take advantage of tax benefits. However, studies have shown otherwise - older investors tend to be really bad when it comes to applying their investment skills to the market. Older investors have poorer diversification skills and consistently underperform the market in terms of stock picks.
Myth #3: Monitor your investments all the time
Reality: You do not need to track your investments 24/7. Some assets may require more monitoring than others, e.g. mutual and other actively managed funds. Short term investments may also require some level of active monitoring to make informed decisions. But watching your investment every moment will be more detrimental both to your mental health and your finances. As an investor, you must keep a cool head when the markets fluctuate, but this can be difficult if you're always following the market. Studies have shown that investors place more importance on their psychological well-being than on their financial well-being when making investment decisions. To ensure mental well-being, investors may even continue to implement a bad decision. In fact, studies show that even after getting a lot of bad information about their initial plan of action, investors continue to stick with it.
Myth #4: Investing is for the rich
Reality: While one does not need to be a millionaire to invest, the reality of investment is a dark one. Sure, you can start small and it will eventually grow, but the investment gap between the rich and poor should not be avoided. Logically, someone wealthy will have more capital to invest in, and the returns will exceed those of an individual with a low income. A low-income individual will have less money to invest in the first place.
However, there are many investment options that do not require a large amount of capital. A retirement account is an example-even if one does not contribute voluntarily or max their accounts, there is still the option for an employer to contribute to your pension, even if the amount is small. Other examples include alternative investment platforms that offer investments with a small amount of capital. Although most of the alternative platforms will be riskier, it is a good way to test the waters with a few euros.
Myth #5: You lose more money to the market
Reality: When it comes to investing, investment fees are the primary source of lower ROIs, not market losses. Investment fees can include fees to the broker or a financial advisor. Market losses are not as consistent as investment fees. Just as compound interest can grow your returns, investment fees can also compound and eat away a significant portion of your income. As your portfolio grows, so do your expenses because they are percentage-based.
Now, let us back it up with some actual studies done on it. A study done by the European Securities and Markets Authority (ESMA) found that fees (ongoing, one-off fees plus inflation) lowered ROIs average by 29%. The reduction in money is higher for actively managed funds than passive ones. How high, you may ask. The lower ROI was estimated up to 11% for passively managed funds but 44% for actively managed funds.
A study by Nerdwallet estimated that paying a mere 1% in investment fees would cost an investor more than $590,000 over 40 years. That very same investor could save nearly $215,000 in fees and retire with $533,000 more if he has paid fees 0.93% or lower.
There are many proponents for low-cost investment, and an experienced investor would always suggest looking for brokers with the lowest costs because they have seen the difference in their money. One way to measure whether the fees are reasonable is to look at the expense ratio.
An expense ratio calculates the fees for portfolio management divided by the value of the fund. And a reasonable expense ratio for an actively managed fund should be around 0.5% to 0.7%. For passive funds, the rate should be 0.2% or lower.
Myth #6: Emotional investors take more risks
Reality: What many investors actually mean is that emotional investors are impulsive. They exhibit neuroticism with higher anxiety and emotions - a disadvantage when it comes to decision making. They are more aggressive, take more risks, and invest in riskier assets, contrary to "rational" investors who invest conservatively.
The reality of emotional investing is quite the opposite. Regarding investors with higher anxiety, the results are more balanced. Investors with high neuroticism were conservative in their investments but not too risk-averse. They spent more time researching before decision-making, leading to good investment performance.
Secondly, impulsive investors are not emotional - they are what they are: just impulsive. People should be looking at having emotional intelligence, a topic studied by financial institutions regarding investments. Emotional intelligence means having the ability to identify emotions and use them effectively, which seems more beneficial for investment performance. A study by the CFA Institute on emotional intelligence and its impact on investment behavior found that investors with high emotional intelligence take decisions that correlate with good investment returns. Such choices include using low-cost funds, not trading too often, changing portfolio too often and etc.
Investors with higher emotional intelligence are less aggressive. They take fewer risks and are less likely to engage in riskier investments. Their study concluded that "emotional" investors were more likely to pursue a balanced portfolio.
Myth #7: Alternative investments are riskier and more illiquid than traditional investments
Reality: The first argument against Alternative investments is that they are riskier than traditional investments. A good rebuttal is that all investments are, and alternative investment is no exception. Therefore, to call it volatile in isolation is an easy argument but not a valid one. The reason people are wary of alternative investments is because of their availability to people through innovative measures, such as offer low-costs, a high-tech user interface, and generous returns.
A study by Blackrock found that alternative investments are just as risky and volatile as traditional investments and sometimes even lower. Sometimes, it can be more dangerous, but it depends on the asset itself. An alternative investment can lower a portfolio's volatility because it adopts several different strategies and assets that have low correlations. Hence, the overall portfolio will not be significantly affected if one asset class loses market value.
The second argument against alternative investment is that the money invested in it is illiquid. That means one cannot access the liquid cash. Again, the reality is - it depends. Liquidity varies on investment options. Some offer daily liquidity, and some do not. Quanloop is an example of a high-liquidity investment. It is up to the investor to decide his goals on investing in alternative investment - he could aim for high returns or aim for high liquidity or both. That is the tradeoff the investor has to choose between. However, it is general knowledge by now that regardless of what the investment institution offers, an investor is likely to grow his wealth more over the long-term if he compounds without withdrawing too often.
Of course, people still believe in the popular investing myths that alternative investment is not a good hedge against financial crashes, as it failed to protect investors from the financial crisis of 2008. However, while it is true that alternative investment lost market value, the decrease was lesser than stocks, and the diversified portfolio acted as a safety net for investors who could have lost more. Stocks have lost above 50% in value of total assets in 2007 and 12% after 2010. AI lost only 7% in 2007 and 15% after 2010. Alternative investment suffered losses, true, but not as much compared to the overall market indices.
Summary
Investment myths can prevent you from doing the right thing. So, don't succumb to such fallacies. Many financial planning misconceptions are perpetuated due to a lack of financial knowledge. Some myths are closer to the truth than others, but everything is in moderation. Investment is risky, but not too risky to avoid it altogether. You should have some basic knowledge to invest, but you do not need to study it extensively to start. While you should track your investments to some level, you do not need to monitor them every day. While investors lose some money to fluctuation, you are more likely to lose more to your fees than the market itself. And last but not least, impulsive investors are not the same as emotional investors. Emotional investors simply mean an investor with higher emotional intelligence who is likely to research more before investing. Impulsive investors just buy assets on impulse.
Plentiful harmful myths regarding investments and personal finance are going around that we did not discuss. It is easier to share misinformation and not be held accountable for it. What we suggest is the investor to conduct due diligence himself before making any financial decisions. Investing myths carry risks that ought to be avoided to ensure stable wealth growth.