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Common Fallacies of Investing

The key to successful investing is to avoid making fundamental mistakes that have plagued many retail investors.

Retail investors - with minimal or no investment knowledge, are likely to be prone to investment slip-ups. Wrong information and misconceptions about funds, and a lack of discipline in investment approach only increases their likelihood of making investment blunders. As a result, many investors often end up commiting the "cardinal sin" of investing such as buying high or selling low or blindly adopting a buy or sell decision based on hot tips, sales talks, gut feel or emotional feelings such as greed and fear.

Few investors are likely to forgive or forget the losses their funds racked up in the past. While many investors attribute terrible performance to bad market conditions, there is more to fund losses than meets the eye. Indeed, the losses from fund investing generally arise due to a few mistakes which are commonly committed by the typical investor.

According to a Boston-based investment research company Dalbar, the average investor in the United States actually underperforms the average mutual fund from 1986 through 2005 because of the investor's bad habits of switching from one fund to another, chasing hot returns while buying high and selling low.

Here are some of the most common investing pit-holes that have been leading many investors down the foolhardy investment lane. Make sure that you avoid falling into these traps.

Fallacy: Using historical returns to select funds
One of the most fundamental mis-steps that retail investors often make is to choose funds based on past performances. Picking funds based on past performances is unlikely to lead to potential winners because past performance is never a reliable gauge of future performance. Many a time, last year's winners may be this year's losers. This is because top performing funds which have reached their peak in a particular period, generally will correct in prices over the next period.

Why then do people make mistakes like that? One of the reasons is that it is easy to look up the newspaper and find one fund that is performing well and invest in it. It makes people feel good that they have invested in a "top-performing fund".

Instead of using past performance as a extrapolation to future performance, historical returns should only be used when analysing the consistency of a fund manager over a period of time or to have a gauge on how the fund manager will perform in a particular market. As such , if similar market cycles were to appear again, then by analysing past performances, investors might have a feel on how the fund manager will perform in comparable conditions.

Fallacy: Buying into "hot" funds
Investing in "hot" or "flavour of the month" type of funds, which is a very common trait among retail investors, usually leads to detrimental results. Launching hyped-up funds when a particular sector or an asset class is hot is usually a fund raising exercise practised by the fund industry to raise easy money. investors shoudn't get drawn into that game.

Funds that have been launched or re-launched on the basis of a red-hot sector or asset class generally are overvalued in nature and more often than not, a correction in prices would generally follow. During the height of the global internet stock bubble from 1999 to early 2000, a slew of technology funds were launched en masse. Shortly after, many of these hot tech funds went into a free-fall mode when the global tech stock bubble burst.

Fallacy: Under and over-diversifying
There is a saying that failing to diversify and putting all your eggs in one basket often leads to investment calamities. The risk of not diversifying enough is very real. Putting all your money in one or two high-risk funds - usually the ones that have the highest potential gains - can create substantial damage to your investment portfolio if the performance of those particular funds takes a turn for the worse.

To avoid taking such concentrated risks, investors - taking into consideration their risk profiles and investment needs - should spread their money over a portfolio of funds that are diversified across asset classes, sectors, geographical regions, investment styles and fund managers.

But at the same time, too much diversification such as owning too many funds has its own setbacks. With numerous investment options to choose from in Singapore and with a constant flow of aggressively marketed new funds coming into the market, it would be easy for the retail investor to fall into the trap of amassing too many funds. Owning too many funds, especially those of the same kind, can lead to a possible dilution of returns over the long run with negligible benefits to risk reduction.

Fallacy: Stop contributing to investment plans during hard times
A common knee-jerk reaction when the market nose-dives would be to hold off all investments until the market recovers. If your investment strategy calls for putting money in a well-diversified investment product, then you should continue to do so even if the financial markets take a severe tumble.

Letting fear get the better of you by stopping your investment plans during difficult market conditions may not only jeopardise your long-term investment goals but it can also cause you to miss out on great investment bargains. Investing during a bear market in anticipation for a rebound over the longer-term often reaps the disciplined investors the greatest gains. Hence it is best to stay invested rather than to time the market.

Path towards successful fund investing
Successful fund investing doesn't need to be complex. If investors could eradicate the fallacies of picking funds based on past returns, buying into hot funds, failing to diversify or over diversifying and ceasing to contribute fresh money in an investment plan during market downturn, they are already well on their way to achieve respectable gains over the long-term. All they need to do further is simply to keep an eye on how funds perform and rebalance periodically. It is really as simple as that.

By, HSBC Insurance, The Sunday Times, 11 May 2008