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The Five Biggest Stock Market Myths
When fiascos like the Enron bankruptcy, auditing scandals and
analysts' conflict of interest occur, investor confidence can
be at an all-time low. Many investors are wonder whether or not
investing in stocks is worth all the hassle. At the same time,
however, it's important to keep a realistic view of the stock
market. Regardless of the real problems, common myths about the
stock market often arise. Here we go over these myths in order to
bust them.
1) Investing in stocks is just like gambling.
This reasoning causes many people to shy away from the stock
market. To understand why investing in stocks is inherently
different from gambling, we need to review what it means to buy
stocks. A share of common stock is ownership in a company. It
entitles the holder to a claim on assets as well as a fraction of
the profits that the company generates. Too often, investors think
of shares as simply a trading vehicle, and they forget that stock
represents the ownership of a company.
In the stock market, investors are constantly trying to assess the
profit that will be left over for shareholders. This is why stock
prices fluctuate. The outlook for business conditions is always
changing, and so are the future earnings of a company.
Assessing the value of a company isn't an easy practice. There are
so many variables involved that the short-term price movements
appear to be random (academics call this the Random Walk Theory);
however, over the long term, a company is only worth the present
value of the profits it will make. In the short term a company can
survive without profits because of the expectations of future
earnings, but no company can fool investors forever - eventually a
company's stock price can be expected to show the true value of
the firm.
Gambling, on the contrary, is a zero-sum game. It merely takes
money from a loser and gives it to a winner. No value is ever
created. By investing, we increase the overall wealth of an
economy. As companies compete, they increase productivity and
develop products that can make our lives better. Don't confuse
investing and creating wealth with gambling's zero-sum game.
2) The stock market is an exclusive club in which only brokers
and rich people make money.
Many market advisors claim to be able to call the markets' every
turn. The fact is that almost every study done on this topic has
proven that these claims are false. Most market prognosticators
are notoriously inaccurate; furthermore, the advent of the
internet has made the market much more open to the public than
ever before. All the data and research tools previously available
only to brokerages are now there for individuals to use.
Actually, individuals have an advantage over institutional
investors because individuals can afford to be long-term oriented.
The big money managers are under extreme pressure to get high
returns every quarter. Their performance is often so scrutinized
that they can't invest in opportunities that take some time to
develop. Individuals have the ability to look beyond temporary
downturns in favor of a long-term outlook.
3)
Fallen angels will all go back up, eventually.
Whatever the reason for this myth's appeal, nothing is more
destructive to amateur investors than thinking that a stock
trading near a 52-week low is a good buy. Think of this in terms
of the old Wall Street adage, "Those who try to catch a falling
knife only get hurt."
Suppose you are looking at two stocks:
-
XYZ
made an all time high last year around $50 but has since
fallen to $10 per share.
-
ABC
is a smaller company but has recently gone from $5 to $10
per share.
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Which stock would you buy? Believe it or not, all things being
equal, a majority of investors choose the stock that has fallen
from $50 because they believe that it will eventually make it back
up to those levels again. Thinking this way is a cardinal sin in
investing! Price is only one part of the investing equation (which
is different from trading, whch uses technical analysis). The goal
is to buy good companies at a reasonable price. Buying companies
solely because their market price has fallen will get you nowhere.
Make sure you don't confuse this practice with value investing,
which is buying high-quality companies that are undervalued by the
market.
Below is a chart of Nortel's decline. Imagine how much money you
would have lost had you bought Nortel just because it kept on
hitting new lows!
4) Stocks that go up must come down.
The laws of physics do not apply in the stock market. There is no
gravitational force that pulls stocks back to even. Over ten years
ago, Berkshire Hathaway's stock price went from $6,000 to $10,000
per share in a little more than a year. Had you thought that this
stock was going to return to its lower initial position, you would
have missed out on the subsequent rise to $70,000 per share over
the following six years.
Below is a chart of Wal-Mart from 1997 to 2000. We've circled
every time the stock chart hit resistance to reaching a new high.
Those investors who were waiting for the stock to come back to
earth would missed out on a return of 500% or more. What's behind
the stock? It's the company! Wal-Mart is another example of an
excellent company that has dominated its industry by being
innovative and creating value for both shareholders and customers.
We're not trying to tell you that stocks never undergo a
correction. The point is that the stock price is a reflection of
the company. If you find a great firm run by excellent managers,
there is no reason the stock won't keep on going up.
5) Having just a little knowledge, because it is better than
none, is enough to invest in the stock market.
Knowing something is generally better than nothing, but it is
crucial in the stock market that individual investors have a clear
understanding of what they are doing with their money. It's those
investors who really do their homework that succeed.
Don't fret, if you don't have the time to fully understand what to
do with your money, then having an advisor is not a bad thing. The
cost of investing in something that you do not fully understand
far outweighs the cost of using an investment advisor.
Conclusion
Forgive us for ending with more investing clichés, but there is
another old adage that is very much worth repeating: "What's
obvious is obviously wrong." This means that knowing a little bit
will only have you following the crowd like a lemming. Like
anything worth anything, successful investing takes hard work and
effort. A partially informed investor is about as effective as a
partially informed surgeon; he or she will only hurt themselves
and those around them.
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