Trading on a daily basis for the last 15 years, I’ve heard just about every myth there is. A recent conversation with a friend reminded me of some of the key myths that have been around since the dawn of regulated markets (and possibly beyond!). So I thought I’d take a look at my top 10 stock market myths and put them into perspective.
1. Investing in stocks is just like gambling
I get exceptionally frustrated when someone tells me that investing in stocks is like gambling. It couldn’t be more from the truth. Gambling is a zero sum game. You put a bet on and you either win or lose. But when you lose, you will lose all your money.
You can buy a stock, and get it wrong. But you can still walk away from the position with majority of your capital intact. Certainly there are many variables in relation to how you can make or lose money investing in stocks, so it is far more complex than simply betting on black or red. But over the long-term, economic growth provides a reasonable probability that a company’s share price will grow.
Investing is not a zero sum game, and with various strategies available to minimize Risk, the investor has a multitude of approaches to making a return other than just buying low and selling high.
2. You need money to make money
There is some truth to this statement. If you invest $1,000 into the stock market, you cannot expect that it will grow to $100,000 over the next year. Whilst possible, it is highly improbable.
However, if you started with $100,000 and expected to make $10,000 in a year, that is a reasonable probability. A 10% return is achievable through stock investment, although not guaranteed. There are many factors that can influence a stock price, and therefore money management and diversification are extremely important factors in achieving any growth in portfolio value.
Short-term trading strategies can offer the opportunity to achieve high percentage results, but at the same time, are a high risk approach. You can risk losing all the capital you start with if you are unsuccessful.
In the end, you need to start with what available capital you are willing to Risk in the markets. Just have a realistic expectation of what you can achieve, and a method/plan on how to achieve it.
3. The stock market is an exclusive club for the rich
Not any more! Anyone can open a trading account, transfer funds in, and buy and sell stocks at their discretion. The cost of brokerage has never been cheaper, whether that is for your local stock exchange or trading something more exotic internationally.
Information has never been more readily available either. Well before the internet, investors needed to gather their information newspapers or the news. A good stock broker had their finger on the pulse of market sentiment and could provide you with an insight into how the markets were reacting.
How much money you use to invest is the difference between the rich and ‘not-so’ rich. Having a more profound understanding of how the markets work or of industry insight is also a key difference. But that doesn’t mean the average investor is limited to buying stocks.
4. It’s a good company, it will come back eventually
A short-term trade gone bad becomes a long-term invest! Not all stocks that fall in value recover. Do you remember Enron, WorldCom, Babcock & Brown, or Lehman Brothers? These were companies that many had invested in, but failed to exit despite all the negative headlines surrounding them.
Long-term investors have the benefit of Time. And if they are wise with their investing, they won’t have all their eggs in one basket. Therefore, a stock that declines will not decimate their account. As we had discussed previously, the stock market rises over time due to continued global economic growth and expansion, and hence it stands to reason that a stock price that has declined has a good potential to eventually recover.
But holding onto a share purely because you don’t want to accept a loss is a poor management approach. Investors blindly purchase shares with the ‘hope’ that it will go up, and if it fails to do so, it gets put into the bottom drawer and forgotten about. It’s not just the lost value that you need to consider, but it is the lost potential return that you could have potentially made if you had decided to cut the losing position and invest elsewhere.
5. Stocks that go up must come down
There is a little bit of truth about this, but it is not necessarily an absolute statement.
It is exceptionally rare to see a stock price rise and never have a downwards movement. By all accounts, a stock price that rises sharply will eventually find profit taking and selling pressure as investors lock in gains. This has been proven with every ‘bubble’ that has ever occurred.
Standard practice for most advisory firms is to provide Buy or Hold signals on stocks. It is very rare for a research firm to provide a Sell signal. Our view is that stock positions must always be reviewed for Risk, and this means evaluating the potential that the stock price might fall (for whatever reason). Therefore, management of a trade will always consider what action to take if the share price begins retracing.
As the modern stock market continues to increase in volatility, there will be more and more instances where stock prices fluctuate. And this means there is a greater probability that a rising stock price will retrace, and vice versa.
6. Price to Earnings ratio tells you whether stocks are cheap or expensive
Quite often the P/E ratio is mentioned when people are talking about stocks. “XYZ has a P/E of 15, and that makes it a great investment because for every dollar invested in the company, you should be making $15”.
The P/E on its own provides no real evidence that the stock price has the potential to increase in value. Even comparing the P/E of one company to another is not a definitive method of choosing a stock to invest in. It can be helpful in comparing valuations of peer companies in a similar sector.
Nowadays, with the availability of information, the P/E is less important in choosing a stock to invest in, and typically used by inexperienced investors (without considering other data or factors).
7. To make money in the stock market, you must take on high risk
High Risk = Higher Return, or so the saying goes. How much Risk you take will influence your potential return, but you can take a high risk position with a small amount of money, or a large amount of money.
Risk isn’t just how much you put onto a trade, but is defined by how you manage your total capital. For example, if you have a portfolio of $10,000 but decide to put $100 onto a short-term speculative trade, if you lose on that position, then you have lost 100% of the trade, but a very small 1% of your portfolio. In essence, it was a Risky trade, but not Risky in relation to the portfolio.
A high risk position could produce some high returns, but success will be determined by how you manage your portfolio. A string of losses in a row can be managed, but if you put your entire account down on a high risk trade, it could be a hit or miss situation.
8. Buy the rumour sell the fact
Absolutely. All too often stock prices will rise on a rumour, with market sentiment driving the share price higher. Then, once the rumour is either confirmed or denied, or news reveals confirmed information to support the rumour, the stock price will align itself with fundamental valuations.
Once the factual information hits the newswires, the share price has usually already moved. There may still be some directional influence following the confirmation, but if the rumour confirms to be true, then the share price will have already shifted in price to match the expected valuation.
Key here is to act on the rumour. But be aware, this is a speculative outlook as it could turn out to be a false rumour. If you can profit from the speculation and exit before, or as the rumour is confirmed/denied, then it can turn out to be a positive approach.
9. Now is the best time to invest in the stock market
Any time is a good time to invest. It’s how you evaluate the Risk of the position you are taking, and how you manage the position that defines whether or not you are successful investing in the stock market.
There are, however, cycles in the economy and the stock market that will provide higher or lower probability environments for successful investing. For example, when the Global Financial Crisis (GFC) was underway, buying stocks at the peak or throughout the decline could have resulted in lost portfolio value. Depending on timing of entry, this may have taken several months or even a couple of years before stock values had recovered to their entry levels.
The period of 2003 through to 2007 was a booming stock market environment. And although there were stock prices that declined through that period, a larger proportion of stock prices increased as reflected with the gains in the leading indices such as the S&P500 index or ASX200 index.
Market cycles can be evaluated and investment plans implemented to define when to buy or sell stocks to assist in improving market timing processes.
10. Trust the institutional analysis as they are the smart players
As a professional stock and derivative analyst, it is my business to review strategy for my clients to invest in the stock market. But as I tell my clients, it is their responsibility to evaluate my conclusions and decide for themselves whether or not that position is suitable for their portfolio.
I receive professional information from various sources, such as Standard & Poor’s, Morningstar, etc. These institutions have teams of analysts with skills other than my own, and provide information that I can then dissect and use in my own decision making. But just because they are an “institution”, I don’t agree with everything they have to say.
Use all the information you can, that you trust, as part of your decision making process. The key is to make the decision yourself, as a process of having a defined and tested investment plan.