5 Market Myths that Will Destroy Your Portfolio

DollarIt has been a wild couple of weeks. To say the markets are going haywire is a tragic understatement. The market has started a vicious cycle and there’s no sign of it turning around.

All the recent volatility is causing massive sell-offs forcing share prices into a dangerous downward spiral.

Half of the stocks on the NYSE set a new 52-week low yesterday. The NASDAQ is almost in as bad a shape. And anything with a market cap of less than a $1 billion…you don’t even want to look at it.

As we watched a few weeks ago, all of the uncertainty is causing investors to pull out of mutual funds as fast as they can. Last week more than $7 billion was pulled out from equity mutual funds according to AMG Data services. And an additional $2.6 billion was redeemed from bond funds.

The massive sell-off was on top of an absolutely horrible July when investors yanked out more than $23 billion. August wasn’t much better when about $6 billion was pulled out.

It’s getting ugly. Mutual fund flows are a key indicator of sentiment. And right now, investor sentiment is at a precariously low point.

The worst part of it all, I’m afraid, is too many investors are succumbing to emotion. Let’s face it, in bull markets we get away with bad habits. But in bear markets, these habits will destroy our portfolios.

One of the worst habits we can fall into is letting our emotions take over. In times like these, it’s best to take an unemotional look at everything. Take nothing for granted.

So today, I’d like to take a step back and try and dispel a few of the myths that I’ve been watching get pushed on unsuspecting investors. We’ve got it all: gold, Buffett, the bailout, and more.

Market Myth #1: Stocks are “On Sale!” Now is a Great Time to Buy: This is the most dangerous attitude of all. To be honest, it’s rarely a truly great time to buy. Don’t get me wrong, there are a lot undervalued stocks out there. But if we look at the basic movements of stock prices, it’s not hard to see this is not truly a “great time to buy.”

As many investors are forced to relearn every few years, stocks go down a lot faster than they can go up. It’s simple market dynamics. Even in the greatest bull markets, the major market indices are soaring if they are up more than 20% in a year. In a strong bull market indices can climb as much as 15% to 25% each year…for years.

But the downside is years of gains can be wiped out in a matter of months.

Just take a look at what happened in the last four years. In October 2004 the Dow was at 9,800. A three-year bull market pushed the Dow to a new all-time high above 14,000 last October. That works out to an annualized return of 12.5% over three years.

Not too bad. Then the current bear market took hold. Since then, all of the gains have been wiped out. A 12-month downturn has scratched the three years worth of gains.

Stocks go down a lot faster than they go up. So even if a bull market as strong as the last one started today (which isn’t likely) and we got a 12% return, we wouldn’t miss out on much of the upside. The whole time we’re trying to catch the bottom; we could get caught in a further decline.

And for me, waiting on the sidelines and running the risk of missing out on a 12% return, far outweighs the risks of getting caught up in any further sell-off.

Investing is all about odds and expected returns. Right now, the expected positive return is low and odds and costs of more downswings are high. Most of your safe money should be on the sidelines.

It’s OK not to buy stocks.

Market Myth #2: China’s Economy has Decoupled: We’ve heard this argument for a long time. The word “decoupling” has been thrown around a lot. For a while there it looked like “supercycle” was on its way to the dictionary. As the world is quickly learning, this myth is far from true.

Decoupling is when two economies are no longer linked together. In this case, the whole world seemed to believe a decade of double-digit GDP growth in China would allow it to disconnect from the United States. Many expected it would be almost immune to a recession in the United States.

So far, that is not the case. Decoupling will happen…but it takes a lot longer than most people think.

The last major decoupling and economic shift happened about 100 years ago. The United States was the emerging market and the United Kingdom was the superpower in decline. It took 50 years, two world wars, a market crash, a decade-long depression, and a few financial panics before the United States would emerge as the new leader.

Now, China is on its way to emerging as the world economic leader. It’s happening all over again. As we’ve seen in the past though, decoupling just doesn’t happen in a few years. It takes decades for an emerging economy to decouple and then assume a leadership position. This time is no different.

Market Myth #3: The $700 billion Bailout is the Key to a Market Turnaround: As we’ve been saying here at Q1 ever since the bailout was announced a few weeks ago: the bailout is not what really matters, it’s the economy.

It’s always the economy.

Don’t get me wrong, the bailout will be helpful. But in the long run, it doesn’t mean much.

I look at it like this. The global financial system is a complex machine. There are a lot of parts. They all have to run smoothly for the machine to work. That’s not happening right now.

Credit markets are seizing, stock markets around the world are plummeting, the global housing market is falling apart…there is a lot of sand in the gears. It has to be cleaned out and lubed.

Right now, asset devaluations are helping to clean it out. As for lube, the only thing that can lube the machine is confidence. And that’s going to be very hard to come by.

The government can temporarily help provide some confidence by opening up the treasury. It worked during the S&L Crisis in the 80’s. It helped create the softest landing possible in 2002. But it’s only a temporary fix.

The only sustainable source of confidence is the economy. And it is only economic growth that can provide the sustainable lubrication for the machine to run smoothly. In this case, it’s going to take a while for the economy to get fixed up.

Confidence has been shaken, but it hasn’t been eliminated. Since the machine has been running relatively smoothly for decades, I wouldn’t expect this time around to be any different. There have been plenty of hiccups before, but each time the lubrication of economic growth saved the day.

In a couple of years the economic picture will be much brighter. The complex financial machine will then be well lubricated. Only then, will the markets truly recover and set higher highs. After that happens we’ll look back on the next two years as a fantastic buying opportunity.

Market Myth #4: Gold is the “Perfect” investment: At the risk of offending all the gold bugs out there, gold is not the perfect investment. In fact, gold isn’t an investment at all.

If you’re looking for truly great returns on your investments over the long-term, you have to find sustainable growth of value. The best way is to find companies that can grow consistently, generate high cash flows so they can either finance expansion or pay decent dividends, and are fairly insulated from competition.

The best companies you can buy are ones that have widening margins and expanding market share. They’ll give you the best returns over the long term. Companies like that, whether you buy shares or start one yourself, is truly the best way to invest.

Gold, however, offers none of those attributes. It only goes up in value if someone is willing to pay more for it. The returns may be good in a gold bull market, but they won’t be very good over the long-term. Just take a look at the past 26 or 35 year periods. Gold missed out on a lot.

Don’t get me wrong, gold does have some value.

Gold is a great trading vehicle. And the recent volatility in gold prices has made it even better. When something moves 10% in a day, then sees up and down swings of about three and four percent each day, active traders will get very interested. After all, with the amount of leverage you can get with gold futures, you can easily turn a three percent return into triple-digit gains…if you’re on the right side of it.

Gold is also a good insurance policy against financial catastrophe. Keeping 5% to 10% of your portfolio in gold is a good idea. It’ll always be there. Gold is a part of any sound financial plan, but it is far from the perfect investment.

Market Myth #5: Warren Buffett is the World’s Greatest Stock Picker: Warren Buffett has a lot of characteristics that have made him a legend. But calling him the greatest stock picker is probably a bit much.

Don’t get me wrong, he’s a great one, but I don’t think that ability has been the driving force behind his successs. But the likes of Peter Lynch, Bruce Berkowitz, Ken Heebner and a handful of others could justify laying claim to the title. So before you follow his footsteps, you have to remember: Buffett is a long-term investor.

I think his patience is his greatest key to success. He has waited out recessions of all lengths, market crashes, and international crises. When he goes in, he goes in for five years or more. And that ability is what has played a big role in making him a truly successful investor.

You see, long-term investors have the greatest odds of success. In his classic, More Than You Know: Finding Financial Wisdom in Unconventional Places, Michael Mauboussin details how long-term investing is an essential part of being a successful investor. Mauboussin, the Chief Investment Officer of Legg Mason, looks at investment success from a purely mathematical perspective.

He focuses on the probability of success relative to time. As you might expect, the longer someone holds a stock, the greater his odds of success.

For instance, the odds of coming out ahead on a trade with a holding period of one hour is about 50/50 (that’s before commissions too). The odds of a one month holding being profitable is only slight better at 56%. After a year odds increase 72.6%. After ten years, the probability of success soars to 99.9%.

Buffett, as a true long-term investor, has got probability on his side. And that’s one of the first steps to being successful in anything. Whether its investing, poker, sports, etc, you’ve got to put the odds in your favor.

Stocks may be cheap right now, and they’re probably going to get cheaper. The current economic slowdown is going to last a while.

The key indicator to watch is the unemployment rate. Last month the U.S. economy shed another 159,000 jobs and the unemployment rate held steady at 6.1%. That marks the eighth month in a row for job losses.

It’s not just a problem localized to the United States though. The U.N.’s International Labor Organization expects global unemployment rates to uptick from 6.0% to 6.1% this year. And that’s assuming the global economy grows at a 4.8% rate in 2008.

When you consider the state of the U.S. economy, the fact England is on the verge of what could be an even larger financial crisis, and Europe’s economic growth grinding to a halt, 4.8% growth is very optimistic.

Right now, wait for the economy to rebound. Once we start getting the first signs of that, confidence will return and the financial system will go back to normal.

Most importantly, don’t ever forget, you do not have to buy stocks. Sometimes it makes the most sense just to wait.

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