Given the complexity of investment markets and investing along with the massive amount of information available to investors many people rely on logic based on “common sense” or simple “rules of thumb” in making investment decisions.
However, while some such rules of thumb are reasonable, in many cases they are not and can result in investors missing opportunities or losing money. In this note we look at some of these and why they are unreliable.
The trick to successful investing is to be aware that markets (and economies) are highly complex, that they don’t go in the same direction indefinitely, that markets are usually forward looking and that avoiding crowds is healthy.
The AMP’s Doctor Shane Oliver says that all of this is particularly pertinent right now given that share markets are trending higher, and yet we are in recession and unemployment is on the rise virtually everywhere.
Myth #1: High unemployment will prevent an economic recovery
This argument is wheeled out every time there is a recession – like now. If it were correct then economies would never recover from recession but simply spiral down into the sort of crises that Karl Marx predicted would ultimately lead to the demise of capitalism.
Of course no such thing happens.
Rather, the boost to household discretionary income from lower mortgage bills (as interest rates fall) and tax cuts or stimulus payments to households during recessions eventually offsets the fear of unemployment for the bulk of people still employed.
As a result they eventually start to spend more which in turn gets the economy going again.
In fact, it is normal for employing again fearing the recovery won’t last.
Since share markets normally lead economic recoveries, the peak in unemployment often comes a long time after shares have bottomed.
In Australia, the average lag from a bottom in shares following a bear market to a peak in the unemployment rate has been twelve and a half months.
Myth #2: Business won’t invest when capacity utilisation is low
This argument is also rolled out during recessions.
The problem with this myth is to ignore the fact that capacity utilisation is low in a recession simply because spending – including business investment – is weak.
So when demand turns up, profits improve and this drives a pick-up in business investment which in turn drives up capacity utilisation.
So while business investment in key countries right now is poor, providing there will be a pick up in demand – and several indicators are pointing to such later this year – then business investment will start to improve even though many factories are still idle.
Myth #3: Corporate CEOs, being close to the ground, should provide a good guide to where the economy is going
Again this myth sounds like good common sense.
However, senior business people are often overwhelmingly influenced by their own sales figures but have no particular lead on the future.
In the late stages of the early 1980s and early 1990s recessions, anecdotal comments from Australian CEOs were generally bearish – just as recovery was about to take hold.
Note this is not to say that CEO comments are of no value; but they should be seen as telling us where we are rather than where we are going.
Myth #4: The economic cycle is suspended
A common mistake investors make at business cycle extremes is to assume that the business cycle won’t turn back the other way.
After several years of good times it is common to hear talk of “a new era of prosperity”.
Similarly, during bad times it is common to hear talk of “continued tough times”.
But history tells us the business cycle is likely to remain alive and well.
Myth #5: Crowd support for a particular investment indicates a sure thing
This “safety in numbers” concept has its origin in crowd psychology.
Put simply, individual investors often feel safest investing in a particular asset when their neighbours and friends are doing so and the positive message is reinforced via media commentary.
The only problem with it is that while it may work for a while it is usually doomed to failure.
The reason is that if everyone is bullish and has bought into the asset there is no one left to buy in the face of any more good news, but plenty of people who can sell if some bad news comes along.
Of course the opposite applies when everyone is bearish and has sold – it only takes a bit of good news to turn the market up.
And as we saw in March this can be quite rapid as investors have to close out short (or underweight) positions in shares.
The unemployment to keep rising during the initial phases of a trick for smart investors is to be sceptical of crowds rather than drawing comfort from them.
Myth #6: Recent past returns are a guide to the future
This is another classic mistake that investors make which is again clearly rooted in investor psychology.
Reflecting the difficulty in processing information, short memories and wishful thinking, recent poor returns are assumed to continue and vice versa for strong returns.
The problem with this is that combined with the “safety in numbers” myth it results in investors getting into an investment at the wrong time (when it is peaking) and getting out of it at the wrong time (when it is bottoming).
Myth #7: Strong economic growth and strong profit growth are good for stocks and poor economic growth and falling profits are bad
This is generally true over the long term and
