Beware (investing) Truths that are self-evident

October 3, 2006

Somebody bust out the champagne. The Dow just broke its all time closing high of 11,722 (hit on January 14th, 2000). 

If you factor in dividends, anybody who bought the leading Dow index fund (Dow Diamonds exchange-traded fund – ticker DIA) is actually up about 18%, as the index itself does not factor in dividends. 

Still for many, especially the financial media, we are at record levels. Six and a half years later. Around 3% (pre-tax) a year including dividends – and that’s assuming you didn’t panic sell when the Dow was below 8,000.

Now that the stock market is past record highs again we are seeing resurgence in investor enthusiasm. Investors appear to be subscribing to the same pattern of investment idea generation that got the major indexes so ridiculously overpriced in the first place: letting backward-looking information and scenarios guide your current investment decisions. Call it what-ifs, woulda-coulda-shoulda strategies, or just investment soul searching.

The main reason major stock indexes are still down from six years ago is because the majority of stocks dominating these indexes reached absurd valuation levels. In 2000, the businesses were more or less fine (some a lot less…), but the stock prices were out of whack.

One reason the stock prices got so out of whack was because so much investing logic of the day was based soundly on what had been the case in the past: 


<li>Stocks always beat bonds over long time periods. 

<li>Broad market indexing is all you need to do. 

<li>Dividends don’t matter. 

<li>Old economy stocks are almost as dumb as bonds (economic growth was being driven by growth companies). 

<li>P/E ratios are irrelevant in the short run if you’re growing revenues or market share, or even eyeball share. 

<li>U.S stocks always beat foreign stocks long run because they are run with better management, brilliant compensation plans to increase shareholder value, and less big government regulatory oversight. 

<li>Natural resources and commodities are terrible investments at any price. 

<li>Emerging-market stocks are too risky compared to U.S. stocks – and don’t perform well to boot. 

<li>Stocks beat real estate hands down. 

<li>Big, dominant companies are safer and grow faster than smaller companies – you just can’t compete with Wal-Mart, Coke, Microsoft, Merck, etc. 

<li>Inflation is licked. 

<li>Buy on dips. 

<li>Think long term.


Every investment that was a good idea was overpriced, and everything that was frowned upon was dirt cheap.

Back in 2000 when the Dow was at all time highs, all of the above maxims were “true” over the previous 3, 5, 10, or even 20 years. Doing the opposite of conventional investing wisdom would have lead to great returns – following the historically obvious, but ultimately dead wrong, logic of the day is why many investors are still underwater.

We bring this up because six years into a market environment that disproves everything once held as gospel, we are seeing a new wave of bad investing maxims emerge. The signs are everywhere: top-selling books about commodities investing, entire TV networks dedicated to home speculation and the general belief that real estate is the best investment anyone can make (at any price, with any financing scheme), non-stop oil markets coverage on CNBC (gold and oil prices have replaced internet indexes as must-watch market data), and fascination with the incredible investment opportunities abroad (and the downbeat attitude about the U.S. dollar and our global financial strength).

But the real indication to us is the kinds of funds that are launched. Every single asset category that was derided in 2000 gets dozens of brand new ways for investors to join in the fun today: emerging and foreign markets, energy, commodity, and other natural resources, inflation-wary, real estate, dividend and other yield-capturing strategies, etc. 

Mutual funds aren’t good enough anymore. Now it’s mostly about exchange-traded funds, or ETFs. The primary perk of ETFs over plain vanilla open-end index funds from Vanguard is the ability to trade frequently and put in stop-loss orders so you can avoid the dips rather than buy on them. 

Some new funds are even based on historical data patterns – sound academic research drives the basis of these bold new funds. In recent years we’ve seen several dividend-oriented funds and ETFs launch. Vanguard changed and renamed a utility fund a dividend growth fund a few years back. 

Dividends have positive connotations where growth or tech once did. Dividend-paying stocks have outperformed no-dividend growth stocks in recent years by a wide margin – some data says over decades. Of course, the same backward-looking data would have pointed to the opposite conclusion when the Dow peaked in early 2000. Back then, it would be easy to show that stocks with strong, top-line growth – or even stocks with higher P/E ratios or no dividends – generally beat stodgy dividend payers. The near no-dividend Nasdaq index outperformed any index with higher dividend yields in the 1990s.

Most of the funds launched in the last couple of years would have been laughed out of existence in 2000. Maybe because its Yom Kippur investors feel a need to right past wrongs by atonement: “I was wrong to hate (dividends, value, foreign companies, energy, bonds, fundamentals…). I admit my mistakes and will now invest in the XYZ International Real Return Fundamental Small Cap Value Dividend Fund.” 

So what should an investor do to avoid making the same mistakes? Own mega-cap stock funds, even market-cap weighted index funds like the S&P500. Own some tech and telecom. Keep foreign, small-cap, and emerging-market holdings to a minimum. Favor growth over value. Avoid commodities completely. Own a good chunk of low-fee, short-term bond funds. Don’t worry too much about inflation. Avoid ETFs that target focused sectors or areas that are popular with investors today. Don’t buy a second home or a bigger first home. Sell a second home if you have one. A home is a home first, a way to avoid rent second, and only a so-so investment third. Don’t renovate your house for “investment” reasons with borrowed money. 

Today’s new investing rules are almost the exact opposites of the 2000 era rules. Investors hold these new truths to be self-evident. Of course, these new investing truths are only evident looking backward, just like the last batch of brilliant investing ideas.