3 Big Misconceptions About the Market That Could Hurt You as an Investor
Misunderstandings about a few stock market basics and what diversification truly means can lead you to some very expensive mistakes.
The three most valuable words you can say as an investor might be, “I don’t know.” Admitting when you don’t know something opens the door to asking questions, seeking information and learning something new. From there, you can better position yourself to make higher-quality decisions.
But instead of saying those three little words, investors tend to fall victim to three big misconceptions that cost them money on their investments. Here’s what to know about what’s often misunderstood when it comes to the stock market, so you can avoid making the same mistakes.
Misconception: You Invest in the S&P 500, So You’re Diversified
Another way to put this misconception is that you assume that the S&P or Dow Jones is the stock market — and it’s not.
Sure, you’re more diversified by investing in the S&P 500 than you are if you put all your money in a single stock position. But you’re only diversified within one segment of the market. The S&P 500 represents under 40% of the entire global stock market.
True diversification is important to mitigate investment risk while capturing as much return as you can from the whole market. Sticking with only the S&P 500 could leave you missing out. Just look at returns from 2000 to 2009 as an example. The annualized total return over that decade was -0.95%.
But if you look at the MSCI Emerging Markets index for the same time period, the annualized total return was 9.78%. You could have missed out on significant growth because you thought you were “diversified enough” by throwing money into a fund that tracked the S&P — and you also took on more risk because you lacked diversification.
In this decade, that lack-of-diversification risk showed up as a virtual 0% return for 10 years. I’m not just saying all this to make the S&P look bad, nor is the point here that investing in this index is a bad thing in general. It could make an excellent part of your portfolio, and that’s the real takeaway here. The S&P 500 alone is not broadly diversified.
In fact, if you look at 2009 to 2019 then you get a different picture. Over that time period, the index’s annualized return was 9.7% while indices like the MSCI Emerging Markets didn’t fare as well, returning just over 5%. Again, I don’t intend to pick on the S&P 500 — I use it as my leading example here because that’s what most Americans will point to if we start talking about “the market.”
This is what a lack of diversification in either direction can do to your portfolio over an entire decade. And if you’re trying to create your own wealth, you have to think in terms of decades, not just months or even years. Think big picture to set up your portfolio, so you can build an investment program that takes performance over time into account and properly diversifies you to protect against some investment risks for the 30 to 40 years that you will likely be investing.
Misconception: You Invest in the Market – So Whatever ‘the Market’ Does Is What Your Portfolio Does
Using words like “the market” is really ambiguous and doesn’t actually specify what you’re talking about … because there’s a stock market. And there’s a bond market. And there are other markets, too.
The whole goal of creating a portfolio that fits your needs and your risk tolerance is to have the right balance between stocks and bonds and market segments. Bonds, in general, are probably not doing the exact same thing as “the stock market.” Your specific asset allocation and the way you diversify your investments may cause performance to look very different than a general measuring stick like the S&P 500.
The bottom line? You have no idea what your portfolio is doing until you look at your portfolio. This misconception usually kicks in for people who watch or read a lot of financial news, which tends to be the last place you want to go to understand what’s happening with your specific investments.
Be wary of generalizations about both current market performance and predictions about what could happen next. They could lead you to make some ill-informed decisions about your portfolio that you could easily avoid by simply tuning out the noise.
Misconception: Your Portfolio Did Worse Than Someone Else’s Over the Last 2 Years, So You Should Change Yours
Over the past two years, large growth stocks have done really well. Small value stocks have not done well. Therefore, if you have a portfolio with more small value stocks than growth stocks, your portfolio probably underperformed the market over that time period.
If you’re comparing two portfolios and one has more small value and the other has more large growth — and this is just an example, you could compare any two asset classes — the mistake would be to say, “because mine didn’t do as well over those two years as so-and-so’s, I need to make adjustments and chase the same returns that so-and-so received.”
Why? Because any two-year period does not make or break an investment strategy. But chasing those returns can. It’s a bit like trying to change lanes in traffic; by the time you realize the lane next to you is moving faster than yours and you maneuver over there, it stops — and guess which lane is moving now? The one you just left.
This is how average investors lose out in the market. By the time they realize another asset class than the one they’re investing in is doing well, they’ve likely missed the upswing and they take on massive risk of that market segment performing poorly by the time they adjust their portfolio. They also risk abandoning their strategy right before the assets they were invested in start rising in value!
You not only have to understand how you’re invested (what asset classes and what percentages), but you also need to consider the historical, longer-term, 10-plus-year performance of those asset classes. Taking a thin slice of any two- to five-year period does not give you enough information to make major decisions — like totally swinging your portfolio in another direction in an attempt to chase returns.
You should set your strategy based on what you believe in for the long term, and stay that course for the long term.
About the Author
Founder, Beyond Your Hammock
Eric Roberge, CFP, is the founder of Beyond Your Hammock, a virtual financial planning firm that helps professionals in their 30s and 40s make mindful decisions with their money and strategically use their incomes to achieve financial freedom. Eric is one of Investopedia's Top 100 most influential financial advisers and is a member of "Investment News' " exclusive 40 Under 40 class of 2016.