When fiascos like the Libor scandal, London Whale scandal, and analysts' conflict of interest occur, investor confidence can be at an all-time low. Many investors 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 are five of those myths.
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 supposed to 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 For Brokers and Rich People.
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.
3. 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 adage, "Those who try to catch a falling knife only get hurt."
Suppose you are looking at two stocks:
- X made an all-time high last year around $50 but has since fallen to $10 per share.
- Y is a smaller company but has recently gone from $5 to $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 $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.
4. Stocks That Go up Must Come Down.
The laws of physics do not apply in the stock market. There's no gravitational force to pull stocks back to even. Over 20 years ago, Berkshire Hathaway's stock price went from $7,455 to $17,250 per share in a little more than five 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 $170,000 per share over the years.
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. 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.
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.
The Bottom Line
Forgive us for ending with more investing clichés, but there's 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. Like anything worth anything, 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.