When investing we all make assumptions about the right criteria for choosing investments and the best way to manage risk. Unfortunately, TIAA-CREF's recent Built To Perform survey shows that our core notions about investing are sometimes seriously flawed or flat-out wrong. Here are three examples of misguided thinking identified in the survey that you should avoid if you want to invest effectively for retirement or any other financial goal.
Misconception #1: Short-term results are the best barometer of performance. When researchers for TIAA-CREF asked 1,000 investors what time period was most important for evaluating an investment, more than half (52%) chose quarterly or annual performance rather than spans of three, five or 10 years. Nearly half (47%) of those polled also admitted that they had bought an investment based on how it fared over the previous year. That's not surprising, I suppose, considering the inordinate amount of attention the financial press lavishes on short-term gyrations of the market and the fact that in late December of every year business sites are chock-a-block with lists highlighting the best- and worst-performing investments for the year.
But when you consider that in most cases you'll be investing money you won't tap for many years, if not decades in the case of retirement accounts, choosing a stock, mutual fund or ETF on the basis of how it fared the last three or 12 months makes little sense. If nothing else, applying such a short-sighted yardstick could leave you with a portfolio skewed toward whatever investments happen to be most popular at the moment, which may also be most likely to be overpriced.
A better approach: instead of focusing on any single time span, consider how an investment has performed vs. its peers over the course of several market cycles that include both upswings and downturns. You can do that by plugging in a fund's or ETF's name or ticker symbol into the Quote box at Morningstar.com and then clicking on the Performance tab. Remember too that research shows that those with the lowest annual fees tend to generate the highest returns—and investment account balances—over the long term.
Misconception #2: Diversification eliminates investing risk. Diversification is one of the most widely known investing concepts, but it's often misunderstood. For example, when asked about the benefits of diversifying, 71% of those polled for the TIAA-CREF survey said they believed they could eliminate investment risk entirely by building a diversified portfolio.
That's simply not the case. Pretty much any fund that owns stocks—including the most broadly diversified stock index funds—will go down when stock prices tank. Still, diversification can be a powerful tool for managing risk. For example, by buying a fund that owns dozens or hundreds of stocks instead of investing in just a few shares of individual companies, you protect against “specific stock risk”—that is, the danger that your entire portfolio's value will be decimated due to problems affecting only a particular company or industry. And by spreading your money among several different asset classes—stocks, bonds and cash equivalents—you may able able to limit the damage your portfolio suffers in times of stress. During the financial crisis, for example, while stocks got hammered, bonds continued to generate returns.
To build an effective portfolio you need to understand what diversification can and can't do, and shed unrealistic expectations about the benefits that diversifying can offer.
Misconception #3: Taking more risk guarantees superior returns. Most investors are aware that there is a link between risk and return. But many don't fully understand how that relationship actually works. To wit, 53% of the people polled for the Built To Perform survey said they believed that higher risk guarantees bigger returns.
That, of course, isn't true. Some high-risk investments generate a huge payoff. Some deliver average or mediocre returns. And some fizzle and result in losses, small or large. So focusing on investments with the highest risks in no way assures that you'll earn outsize returns. Depending on how skillful (or lucky) you are in choosing among high-risk options, you may come out a winner, a loser or somewhere in between. But there are no guarantees.
What is true, however, is that shooting for higher returns always means taking more risk, whether that risk comes in the form of more volatility or outright loss of principal. Fail to grasp that distinction—that higher returns always involving more risk isn't the same as more risk always leading to higher returns—and you may have a tough time reaching your financial goals.
Walter Updegrave is the editor of RealDealRetirement.com. If you have a question on retirement or investing that you would like Walter to answer online, send it to him at email@example.com. You can tweet Walter at @RealDealRetire.