The word diversification has a slight positive connotation to it.…
In the world of investing, there are times when we know some, and times when we don’t know some. In this post I attempt to clear some of these investment fallacies or investing aspects we tend to overlook:
1. Currency linked assets
Currency linked assets include bonds, stocks, real estate or anything that you can invest in. What you need to be aware of is that all of these assets are denominated in some kind of currency, and what currency they are settled in can impact the overall return you are getting. I have heard of HK people who are interested in Japanese real estate, without factoring in the potential depreciation (or appreciation) of Japanese yen against Hong Kong dollars. Or many people claim the US Treasury bonds are one of the safest assets in the world, but if you factor in the steady depreciation of USD within the past few years, you may be losing money instead (of course currencies pegged to USD are exempt from this)! Also, there are fees incurred when converting from one currency to another currency, and sometimes these fees can cost just as much as the commission itself… or even more!
Companies that pay dividends on a consistent basis are usually noted to be safer – they have the cash to consistently pay out part of the earnings to its investors. That is what make companies with high dividend yield attractive to some people. However, there lies a problem with focusing too much on dividends. The first is that if you invest in a company that has high dividend yield, it means it isn’t retaining a lot of money to invest in itself. Secondly, some investors have wanted to invest in dividends so they can receive a steady income on a monthly basis. But they forget to note that the payout of dividends will be deducted in the share price on the ex-dividend date. For instance, a share priced at $10 paying out 10% dividends means it will give you $1, but the share price will be adjusted to $9. These investors think the concept of dividends is the same as bonds that pay interests, when it’s not. So what’s the point of dividends if my share price is adjusted for the payment of it anyway? Well I won’t go to extreme details but some pointers: a) in case the company bankrupts for whatever reason you already pocketed the dividends first, b) an adjusted share price may be more attractive for other investors to purchase the share.
Bonds are often considered one of the safer investment alternatives. Some people like to have bonds so that they can have a steady income. However, please be aware that bonds are not as simple as you may think! You can lose all your money in bonds if the company you invested in decides to default, and sometimes investing in bonds may not guarantee interest payment (especially if the company has bad liquidity). Although prices are generally not as volatile in the stock market, bond prices will fluctuate as well. So if you’re planning to sell before the bond matures, you have to potential to lose money even after receiving interest payments! And as I mentioned earlier, bonds can also be denominated in a different currency, so you may lose money from a drop in bond price AND currency devaluation. Some bonds may also carry different clauses with them (ie. redemption, convertible etc.) so be sure to ask your account executive on anything you may be unclear of. Speaking of which, a coupon rate and the bond yield are very different. The coupon rate is the fixed % that the company pays to its lenders bought at the original price. The yield is the % you’ll be getting for buying at market price. For example, 10% coupon and a $1,000 par value. The company will annually pay $100 to each $1,000. Now if you’ve managed to purchase the bond at $500 for example, because the company is still obligated to pay you $100, your yield suddenly shoots up to 100/500 = 20%! And of course, the opposite is true when you buy at a higher par value. There is much more to bonds and I suggest for those interested to go to www.investopedia.com
4. Difference in Fund Commissions
Planning to invest in a mutual fund but don’t know which one? You’ve decided the sector or region you want to invest in and you noticed that there are many funds that suit your requirements. One aspect of your consideration may be the difference in management fees. You notice for example that Fund A may be much cheaper than Fund B, so you invest in Fund A. But be careful! If the fee differs widely, you may have overlooked some of the other fees Fund A is charging that Fund B isn’t charging, and the total of these fees may end up taking a bigger % of your profits than fund B!
5. You’re not raising capital for the company you’ve invested in
Unless you’ve purchased the company’s shares during its IPO. Let’s say Company “Raise Money” has raised USD 100m during its IPO. After 6 months, you’ve decided to purchase this company, thinking that your money will give it more capital. This is a false reasoning. No matter what price you buy the shares at, the company will only have its USD 100M raised from its IPO. Many times you hear critics say that so and so purchased unethical companies like tobacco, claiming that so and so is helping the company by giving capital to it directly. While the critics are right in saying that so and so will be giving more incentives for the tobacco company to continue its business (employees with stock options are incentivized to make company grow so that their stock prices go up; also so and so will more than likely encourage other people to use tobacco so the company gets more profit), it is wrong to say so and so is impacting the company directly.
6. When prices are going up, it does not mean there are more buyers
Neither does it mean that there are more sellers when prices are going down. It just means people value the company at a more expensive price when prices are going up, and vice versa. Imagine you bought a toy at $10 and you sold it for $20, does it mean that there are more people buying it? When the stock market is going up however, it does mean everyone is getting wealthier (or less poorer). Imagine a scenario where the stock market was going up linearly. No matter what price you buy it at, as long as you’ve purchased the shares, you would have made money. Every buyer becomes a winner. I buy the share at $1, you bought it at $2, she buys it at $3, and it keeps going up. Everyone comes out with a profit. Similarly, when the stock market is going down, buyers become losers. I purchased at $10, you purchased it at $9, she purchased it at $7, and it keeps going down. Every buyer becomes a loser.
The ultimate message that I hope you take away from reading this post is that investments are not as simple as you think and that basic homework is essential for better understanding of what you’re getting yourself into. Always, always read the terms and clauses associated with the investment products that you decide to purchase.
What other investment fallacies can you think of?