The investment realm is full of conventional wisdom, advice that some investors and financial professionals repeat and act upon without checking up on its validity.
Some of this guidance is just fine, such as the notion that diversifying among asset classes can help reduce your portfolio's risk level.
Other investment chestnuts, meanwhile, don't stand up to closer scrutiny. Some kernels of investment wisdom are more effective as sound bites than portfolio-management tools; others were perhaps valid at one point but new data have cast their validity into question.
Here are some “investment rules” that you should ignore:
1. Consistency is king when it comes to investment selection.
Financial pundits often tell investors to seek securities that have been "consistent" over various calendar periods, whether it's funds that have landed in their categories' top halves in every calendar year or companies that deliver consistent earnings quarter-in and quarter-out. That advice may have intuitive appeal, but it ignores a couple of key facts.
For one thing, good luck and the vagaries of the calendar can shape a fund's "consistency" just as much as investment merit can. Bill Miller's Legg Mason Value Trust famously beat the S&P 500 Index in 15 straight calendar years, for example, but lagged it in many other rolling 12-month periods. But as Miller readily pointed out, his "streak" was more an accident of the calendar than it was an indication that his fund would be a consistently strong performer.
More importantly, the best investments, whether stocks or funds, tend to be somewhat "lumpy" in terms of their performance. Their fortunes may ebb and flow from year to year or month to month, but because they've been willing to do something different than their peers, they've managed to end up ahead over the long haul.
If you have a long time horizon for an investment, say, 10 years or more, it's a mistake to focus disproportionately on year-to-year or quarter-to-quarter performance.
If you do so, you may miss out on a truly exceptional--albeit inconsistent--stock or fund that would make a good long-run holding.
Looking at consistency of absolute returns--that is, a fund's ability to avoid real losses--is a more worthwhile exercise, particularly for investors who are close to tapping their assets.
Here again, though, remember that calendar-year returns don't tell the whole story about how risky a fund is apt to be.
It's possible for a fund to have an unblemished record of positive calendar-year returns but plenty of losses over other 12-month periods. (Remember the "accident of the calendar" that I discussed earlier).
2. If an investment has been a laggard over the past three or five years, cut it loose.
Financial consultants and planners often tout "formulas" for managing client portfolios, and one of the most common is to give a holding the heave-ho if it has underperformed its peers over the past three or five years.
I'd agree that it's sensible to have a "sell" strategy in place, but performance-based rules like that one are a recipe for mediocre--or worse--investment results.
Such formulaic approaches seem reassuring on the surface but simply don't make good investment sense.
True, funds or stocks that have been terrible performers for several years running may be fundamentally flawed and entering a death spiral from which they'll never recover. In such instances, it's always better to cut your losses, resolve to learn from any mistakes you made in your analysis, and move on.
In the case of other securities, however, a period of performance weakness may actually be occasion to add to your holdings. The experience of the late 1990s provides a vivid illustration: Regardless of strong fundamentals, any stock or fund without an Internet strategy attached to it fell into deep market disfavor for several years running. Had you reflexively sold your shares based on the three- or five-year rules, you would've missed out on the tremendous subsequent rally in non-Internet-related names.
Simply put, you would've been paying attention to the market's opinion without bothering to consider the underlying attributes of the stocks or funds you were selling.
Bottom line: It would be convenient if a sustained losing streak were a foolproof sell signal, but it's not.
Rather than adhering to pat solutions, the most successful investors are willing to buck current market sentiment and stick with their losers as long as their investment thesis for a fund or stock remains intact.
It's my view that investors who didn't bail on investments with strong fundamentals in late 2008 or early 2009 will be amply rewarded over the next decade.
3. Your "risk tolerance" should be a key determinant of your asset allocation and investment portfolio.
Unlike the previous two pieces of investment advice, this investment maxim isn't completely off-base. Morningstar data have shown that investors tend to mismanage volatile investments by buying and selling at inopportune times. Thus, investors should be sure that they can stomach the highs and lows associated with a given portfolio plan before buying into it.
However, I've increasingly come to believe that an individual's assessment of his or her risk tolerance should play second (or maybe third or fourth) fiddle to other considerations--such as time horizon, the size of your nest egg, your savings rate, and the expected returns from various asset classes--in determining his or her stock/bond mix.
The risks of being too aggressive or too conservative are too great to let your gut--rather than these hard facts--dictate your asset allocation. While most of us would like our portfolios to incur limited to no losses from quarter to quarter and month to month, we simply don't have the luxury of keeping our nest eggs in ultrasafe investments.
Moreover, paying too much attention to your risk tolerance could leave you with an ever-changing asset allocation--some weeks you're feeling good about the market and inclined to take additional risk, while other weeks leave you feeling bearish. If ever there were a recipe for poor investment returns, this would be it.
Rather than letting irrational risk aversion drive your asset-allocation mix, use an online asset-allocation tool, a financial planner, or a target-retirement fund to help steer the way.
These sources of asset-allocation guidance aren't infallible, but they're a big improvement over letting your emotions guide your stock/bond mix.
4. It's OK to move into cash when you're nervous about the market.
When everything's headed down, as it was in late 2008 and early 2009, shifting into cash can have the immediately gratifying effect of shielding your portfolio from losses.
Yet, that sense of relief is often short-lived and immediately replaced by another nagging worry: Is it time to get back in? Was yesterday's 200-point rally in the market a head fake or the beginning of something big? No one knows the answer for sure, of course, so my experience is that big cash-holders find themselves in just as big a predicament as they started in.
According to a recent study, a market-timer who missed the 10 best days of global stock markets' returns over several decades would be 50% poorer than a buy-and-hold investor at the end of the period.
An inability to time the market isn't the exclusive failing of individual investors, either. In fact, professional money managers have failed so miserably at this exercise over the years that most have abandoned it entirely. (A few hold cash as a residual of their bargain-hunting investment processes, but that's different from market-timing.)
The basic takeaway is this: If you have money that you can't afford to lose because you're going to need to spend it in the near future, then by all means keep that on the sidelines.
But if you're investing with a faraway goal in mind, your best bet is to stay invested and not let the market's short term-fluctuations keep you from realizing your long-term goals.
Christine Benz is Morningstar’s director of personal finance. This article first appeared on Morningstar.com, our sister US site and has been formatted for India.