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4 Investment Myths Thumbnail

4 Investment Myths

Investing myths, like all misconceptions, thrive on circular reasoning: They are widely accepted because they persist, and they persist because they are widely accepted. For kids, this logical fallacy sustains belief in the Easter Bunny, Santa Claus and the Tooth Fairy. It is only after kids question their assumptions that they wise up. 

So maybe there’s value in questioning ingrained investing beliefs, some of which may be myths. Here is a look at some widely accepted myths and some compelling reasons to reject them.

1. Inflation invariably damages stock portfolios.

Market history shows that stocks have been the best hedge against inflation 75% of the time over the last 50 years. 

Since 1973, over the course of two-year periods after CPI inflation readings of more than 5%, the best-returning investment has been gold. But over the two-year periods after CPI inflation readings of 5% and under — a level that is likely for much of this year — the S&P 500 has beaten gold, returning 32.8% after inflation between 2% and 3%, 25.1% after readings of 3% to 4%, and 17.2% after inflation of 4% to 5%.

Though gold has beaten this index after readings of more than 5%, the S&P 500 has still rocked, with returns averaging 23%. The other non-gold investment that has done quite well after (and during) high inflation has been real estate investment trusts, because landlords can just raise rents. 

2. Dollar-cost averaging is better than lump-sum investing.

Dollar-cost averaging is a common practice among baby boomers, some of whom may have acquired this habit in the 1990s from reading Money magazine, which repeated the term like a mantra. DCA devotees often buy shares regularly on arbitrary dates (rather than when the price is down) through automatic purchases. 

Of course, while this method helps with investing discipline, in terms of actual returns, it rarely works better than lump-sum investing. The superiority of lump-sum investing is intuitively clear because, when you dollar-cost average in a rising stock or fund (i.e., the kind you want to buy), you acquire shares at higher and higher prices.

This intuition is confirmed by a recent study by Northwestern Mutual Wealth Management that examined returns over rolling 10-year periods from a $1 million investment starting in 1950. The study compared results from lump-sum investment and DCA, assuming that the money was invested evenly over 12 months and that investments were held for three years. 

For an all-stock portfolio, the return from lump-sum investing outperformed DCA 75% of the time. For a portfolio of 60% stocks and 40% bonds, the outperformance rate was 80%.

The only caveat is when investors are concerned on the short, DCA can give them some comfort about the market collapsing after they bought in a lump sum.

3. Options just add risk to a portfolio. 

Views of options are pretty much congruent with views of volatility — a word that prompts palpitations in investors who equate it with risk. Warren Buffett called this a “dead-wrong pedagogic assumption” taught in business schools.

Volatility is an asset class that can be harnessed for gain. A highly effective way to do this is to use option overlays on major indexes. These overlays reduce risk through consistent defensive positions while increasing net returns through regular cash flow. This is not a trading strategy. Rather, it is one that systematically captures option premiums.