Four ‘money myths’ to be wary of

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When I was growing up in the 1970s few people had heard the term “climate change”, most UK electricity was generated from coal and the only electric powered vehicles were milk floats.

Today climate change is widely accepted as one of the most pressing global issues, UK coal power generation is minuscule and, while milk floats are almost as rare as hen’s teeth, electric powered cars look likely to become mainstream over the coming decade.

When it comes to your money you need to base your decisions and actions on current research and best practice, not outdated thinking and ideas — what I call money myths. The financial services industry seems to rely on many widely held but false beliefs to justify its existence and charges. Here are just a few examples of money myths you might have heard about.

1. Most investors significantly underperform funds due to the “behaviour gap”

Investors are often said to mistime the market, selling after a stock’s price has already fallen and buying after a rally. Some studies put this underperformance, known as the “behaviour gap”, at about 4 per cent a year — and many financial advisers and investment managers use the idea to justify their services. The only problem is it’s wrong.

Investors’ returns will often surprise on the upside, and other factors may play a more important role: for instance, they are more likely to do well during periods when markets are steadily growing than in periods of high volatility. In its analysis of annual investor returns, Morningstar’s Mind the Gap study found “the gap between official total returns and those actually experienced by investors across all mutual funds has shrunk to 26 basis points [0.26 per cent] over the 10 years that ended March 2018”.

If investors receive lower returns than the funds in which they are invested, it is seldom because of “behaviour” driven by fear or greed but because they happen to be making most of their planned regular investments or (often unavoidable) withdrawals during a period of poor portfolio performance, over which they have no control. And for those investors who do negatively affect their returns by investing on highs and selling on lows, their behaviour performance gap is about 0.25 per cent, not 4 per cent, a year.

2. You must regularly rebalance your investment portfolio

Rebalancing is the process of selling the components of a portfolio that have risen and buying more of those that have fallen in order to maintain the originally desired asset allocation. Say you start out with 50 per cent equities and 50 per cent bonds and a year later the equities are now 60 per cent and the bonds 40 per cent by value, rebalancing would see you sell 10 per cent of the portfolio representing equities and reinvesting the proceeds in bonds, to bring it back to 50/50.

The problem is no one can say why this makes sense. Michael Edesess, a mathematician, says: “There’s no mathematical or theoretical reason that rebalancing should increase your return in the long run or lower your risk . . . In fact, history shows that rebalancing would have performed worse over long time periods than the obvious alternative: buy and hold.”

Mr Edesess’s analysis of a US portfolio with 50 per cent equities and 50 per cent bonds over 58 30-year periods from 1926 to 2012 shows a rebalanced portfolio would have beaten buy-and-hold in less than 12 per cent of those periods, and in only two of those by more than 0.2 per cent per year. Buy-and-hold would have beaten rebalancing by an average of 0.8 per cent a year.

Rebalancing is not a bad thing, particularly if you think it will impose discipline on you or your investment manager, but it is wrong to think you should always do it or that the fees charged by others to do it for you represent good value.

3. Actively managed portfolios give you a good chance to outperform the stock market

There is absolutely no evidence that anyone can predict which fund or investment manager will beat the market by looking at past performance. Merton Miller, the US economist, said: “If there are 10,000 people looking at the stocks and trying to pick winners, one in 10,000 is going to score, by chance alone, a great coup, and that’s all that’s going on. It’s a game, it’s a chance operation, and people think they are doing something purposeful . . . but they’re really not.”

Another factor to consider when deciding whether active management outperforms the market is the extra you pay in fees for the privilege — quite the opposite.

4. Pound cost averaging brings higher returns than investing your capital all in one go

If you have no alternative, because you are saving regularly from income, then pound cost averaging (buying investments on a monthly basis) is the best plan, but there is no evidence that it reduces investment risk or boosts returns.

A simulation that compared lump sum investing to pound-cost averaging using US returns data for every one-year, three-year and five-year period over the 83 years from 1926 to 2008, found that, on average, investing a lump sum all at once gave a much better return than pound-cost averaging.

There are lots of other money myths — feel free to share your own views in the comment section below.

Always remember that no one will ever care more about your financial wellbeing than you, and they won’t suffer the consequences of any poor outcomes. So, make sure that you don’t take any claims or statements about money at face value. Look for unbiased analysis or independent research to substantiate what you’re being told to separate myths from facts.

Jason Butler is an expert on financial wellbeing and presenter of the “Real Money Stories” podcast. Twitter: @jbthewealthman