Many investors wonder whether they should invest in stocks. Before deciding to invest, it's important to have an accurate understanding of stocks and trading rather than blindly accepting common myths. Here are five of those myths and the truth behind them.
Ten Worst Mistakes Beginner Investors Make
1. Investing in Stocks Equates to 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 represents 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 ownership.
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 is complex. There are so many variables involved that 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 will show the true value of the firm.
Gambling, in contrast, is a zero-sum game. Gambling merely takes money from a loser and gives it to a winner. No value is ever created whereas the overall wealth of an economy increases through investing. As companies compete, they increase productivity and develop products that improve lives. Investing and creating wealth should not be confused 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. However, almost every study done on this topic has proven that these claims are false. Most market prognosticators are notoriously inaccurate; furthermore, the internet has made the market much more accessible to the public than ever before. The data and research tools previously available only to brokerages are now available for individuals to use. Moreover, discount brokerages and robo-advisors allow investors to access the market with minimal investment.
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 Wall Street adage, "Those who try to catch a falling knife only get hurt."
Suppose you are looking at two stocks:
- X reached 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, the majority of investors choose the stock that has fallen from $50 because they believe 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 (investing is different from trading because the latter uses technical analysis). The goal is to buy growth companies at a reasonable price. Buying companies solely because their market price has fallen will yield nothing. Investing in stocks should not be confused 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 to the stock market, and there is no gravitational force to pull stocks back to even. Over 20 years ago, Berkshire Hathaway's stock price rose from $7,455 to $17,250 per share in a little more than a five-year period. Far from coming back down, the stock rose again to over $308,000 per share in February 2019. Although it is not true to state 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 will not continue to rise.
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 do their homework are the ones that succeed.
An investor who lacks the time to do extensive research should consider employing the services of an advisor. The cost of investing in something that is not fully understood far outweighs the cost of using an investment advisor.
The Bottom Line
"What's obvious is obviously wrong" is another adage. It implies that knowing just a little will only have you following the crowd like a lemming. Successful investing takes hard work and effort. Consider a partially informed investor as a partially informed surgeon; the mistakes could be severely hazardous to their financial health.