Many hesitate to enter the market due to common myths about the stock market. An informed investor will adopt a critical approach towards these myths. Thus, the article will discuss common myths that prevail in society.
“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 a stock represents the ownership of a company.
In the stock market, investors are constantly trying to assess the profit that will be left for shareholders. This is why the 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 supposed to be 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.
“Stock market is an exclusive club for brokers and rich people”
Many investment 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 a selected crowd are now there for individuals to use.
“Fallen angels will 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 saying, “Those who try to catch a falling knife only get hurt.”
Suppose you are looking at two stocks:
nX made an all-time high last year around Rs.50 but has since fallen to Rs.10 per share.
nY is a smaller company but has recently gone from Rs.5 to Rs.10 per share.
Which stock would you buy? Believe it or not, all things being equal, a majority of investors choose the stock that has fallen from Rs.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, which 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.
“A little knowledge is better than none”
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. Investors who really do their homework are the ones that succeed.
If you don’t have the time to fully understand what to do with your money, you could obtain the assistance of your investment advisor. The cost of investing in something that you do not fully understand far outweighs the cost of using an investment advisor.
“This is a good time to invest in the stock market”
Is there actually a good time to invest in the market? Ask your stockbroker firm when it warned clients that it was a bad time to invest. A broken watch tells the right time twice a day, but that’s no reason to wear one. As someone once said, asking a stockbroker if this is a good time to invest in the stock market is like asking a barber if you need a haircut. “Certainly, sir -- step this way!”
“Our economists are forecasting”
Ask your stockbroker firm if the firm’s economist predicted the most recent recession -- and if so, when. The record for economic forecasts is not impressive. Even into 2008, many economists were still denying that a recession was on the way. The usual term is to predict “a slowdown, but not a recession”. That way they have an escape clause, no matter what happens. Warren Buffett once said forecasters made fortune tellers look good.
“The market’s really cheap right now. The P/E is only about 13”
The widely quoted price/earnings (PE) ratio, which compares share prices to annual after-tax earnings, can be misleading. That’s because earnings are so volatile -- they’re elevated in a boom and depressed in a bust.
Ask your stockbroker firm about other valuation metrics, like the dividend yield, which looks at the dividends you get for each dollar of investment, or the cyclically adjusted PE ratio, which compares share prices to earnings over the past 10 years. No metric is perfect, but these three have good track records.
“You can’t time the market”
This hoary old chestnut keeps the clients fully invested. Certainly it’s a fool’s errand to try to catch the market’s twists and turns. But that doesn’t mean you have to suspend judgment about overall valuations.
If you invest in shares when they’re cheap compared to cash flows and assets -- typically this happens when everyone else is gloomy -- you will usually do very well.
If you invest when shares are very expensive -- such as when everyone else is absurdly bullish -- you will probably do badly.
Bottom line
The article could be concluded with another old adage 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.
Successful investing takes hard work and effort. Think of a partially informed investor as a partially informed surgeon; the mistakes could be severely injurious to your
financial health.
