Five investment myths you should ignore

published 12 September 2007

There are several rules' about trading that are so well accepted in the market that they are never questioned. But most of them are no more than nonsensical myths...

Myth 1: You can't beat the market

The first and biggest myth is that you can't beat the market. This is complete rubbish. Granted, not many people can, but some, say 20%, can. Have you ever played in any competition where everyone is equal? Of course not: not in sports, academia or the workplace. So why should the market be any different? Stockmarkets are not perfectly priced, and if you're good enough, and if you understand your investments properly, then you can outperform consistently. Let's not forget that Warren Buffett's Berkshire Hathaway has made returns around three times greater than those of the S&P 500 over the last 15 years. The question is: how can you do the same?

I think it's fairly simple. First, you need to understand the competition. Most fund managers are intelligent enough, but their performance is impeded because they cover mostly large-cap stocks, tend to be restricted in what they can buy, and, most importantly, tend to avoid taking contrarian views. Too often they pour cash into equity bubbles only to be hurt when the the bubble bursts. Second, you need to select your battlegrounds carefully. I don't try to be an expert on everything, but instead seek out under-researched sectors where there is a lack of analyst coverage. This exercise requires patience (for every 100 opportunities investigated, less than five are worth buying) and hard work. It's not just about balance sheets; you need to read the trade press, talk to management and even attend industry conferences if you really want to understand a particular company. Finally, before buying a company's shares, you need to work out the underlying worth (or fair value) of the business by calculating the value of future revenues in several different possible scenarios. You must then build in a margin of safety before investing: I only buy if I believe that the company's share price is less than 30% of its fair value.

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Myth 2: You must use stop-losses

Everyone seems to think you should use stop-losses, but to my mind they are a waste of time if you've done your homework. I attend AGMs, participate in analyst conference calls and revalue the shares in line with the company's ongoing results, future prospects and changing sector conditions. If you do this, you really shouldn't need a stop-loss. In fact, you really don't want one. For example, six years ago I bought some shares in MicroTouch Inc, a US touchscreen manufacturer, at £8.62 each. At one point I was nursing a hefty loss of 60% as the institutions sold out in the aftermath of the tech collapse. However, as I knew it would, the business generated solid profits and 12 months later MicroTouch was taken over by 3M, who paid £14.32 a share, delivering a total return of 66% on my original investment. If I had sold prematurely, I would have lost out big time. Success very often depends on the ability to select undervalued stocks not currently recognised by the majority of investors, and in having confidence in them even if the market marks them down.

Myth 3: Run your winners

I'm constantly hearing the phrase the trend is your friend'. However, when a share rockets to a level that no longer reflects its true value, holding on in the hope that it will go even higher is just gambling. Common sense eventually prevails, and the gains will be wiped out: it's a matter of when, not if. So how do you know when to sell? I sell when I find my rationale is wrong, when I find a much better bargain to replace a share in my portfolio with, or when a share looks overvalued and hence vulnerable. If a share in my portfolio looks like it is more than 30% overvalued, I sell it right away and recycle the profits into other more attractive opportunities. Back in 2003/4 I bought shares in Cryptologic Inc, a Canadian online gaming company, at an average price of £6.75. Over the next 18 months, I actively monitored performance and revised upwards my valuation in line with the company's improving results. In early 2005 I thought the shares were worth around £12 and was able to sell them at £15.65. The stock kept climbing and hit a peak near 20. Reality then set in, and Cryptologic is now trading at £14. This kind of disciplined approach misses the top of investment bubbles (and some of the fast gains that can come with them), but it also avoids the subsequent crashes.

Myth 4: Diversification is good

Wrong again. Too many people damage their wealth by selecting stocks solely to create a diversified portfolio. Buying shares based only on diversification delivers average performance. If you possess the skills and are prepared to put in the necessary time and hard work to become a top 20% performer, then why accept being mediocre? If there are insufficient quality investments available, then be patient and wait for the right opportunity. Diversification is only desirable if it's achieved without compromising on the attractiveness of the stocks picked.

Myth 5: Buy and hold

This is a dangerous myth too. The world is changing too fast to religiously adopt a buy and hold' strategy. Companies do not keep increasing their earnings and dividends forever. Businesses like economies go through cycles. Sometimes good, sometimes bad. Moreover, the duration of these cycles is compressing, with markets, technologies, consumer tastes and products all changing rapidly, leading to greater volatility, more uncertainty and higher risk. These are perfect conditions for stock pickers and terrible ones for buy and holders.

Paul Hill also writes a weekly share-tipping newsletter, Precision Guided Investments

Paul gained a degree in electrical engineering and went on to qualify as a chartered management accountant. He has extensive corporate finance and investment experience and is a member of the Securities Institute.

Over the past 16 years Paul has held top-level financial management and M&A roles for blue-chip companies such as O2, GKN and Unilever. He is now director of his own capital investment and consultancy firm, PMH Capital Limited.

Paul is an expert at analysing companies in new, fast-growing markets, and is an extremely shrewd stock-picker.