Don't fall for these five market myths
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Deputy Editor
Tim Bennett Aug 20, 2010
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Plenty of myths surround stockmarket investment – many of them encouraged or even created by the fund-management industry in order to attract more investors into the market. Here are five of the biggest – don't fall for them.
1. There's one magic number
There's nothing wrong with keeping investing simple. But the idea that you can compress a firm's entire financial performance into one number – maybe a price/earnings (p/e) ratio – is fanciful. A p/e alone, for example, may give you a rough idea of whether or not a stock is cheap. But it offers no information on key aspects of a business, such as financial strength, and it's easily distorted by an unusually high or low earnings figure. As Brett Arends notes in The Wall Street Journal, as well as earnings, a share investor should examine dividends (yield and cover), balance-sheet strength (using the Altman Z score, for example) and cash flow.
2. There's one magic indicator
Similarly, you can't rely on one macroeconomic 'rule' to guide your investing. For example, one argument is that when interest rates are low, stock prices rise and vice versa. Low rates mean cheap finance for firms, and therefore growth. Yet as Larry Edelson points out on Marketoracle.co.uk, "there is no standard relationship between stock prices and interest rates". For example, between December 1989 and March 2003 the Bank of Japan's discount rate fell from 4.25% to virtually zero. The Nikkei 225 fell 80% over that period. Conversely, the Fed Funds rate rose from 1.25% to 4.75% between March 2003 and October 2007. The Dow rose 75%.
Or there's the link between profits and stock prices. It seems to make sense that rising profits and rising share prices would go hand in hand. But research from CNBC analyst Paul Kedrosky shows that since 1960 some of the best average annual returns on the S&P 500 came when average corporate earnings were falling at a rate of 10% or more. That's partly because stock prices reflect hopes for the future, not the latest earnings announcement. But it's also because most analysts are hopeless at profit forecasts.
3. Timing doesn't matter
Ask an estate agent when is the best time to buy a house, or a car dealer when you should upgrade your old banger, and the answer is always the same: now. After all, no deal equals no commission. It's the same for brokers and investment managers. None of them gets rich unless you are in the market and trading.
But as anyone who bought stocks at the peak of the tech bubble in 2000 will have learned to their cost, timing matters. Warren Buffett urges investors to be "greedy when others are fearful" and vice versa. Just as canny businesses snap-up assets (people, buildings, even whole rivals) during recessions – when they are cheap – so the best time to buy shares is at times of maximum pessimism. And you want to be selling when markets are euphoric. Sure, no one gets the timing of peaks and troughs spot on other than through luck. But aiming to catch, say, two -thirds of any rise and avoid two-thirds of any crash is realistic. So don't run winners indefinitely. Set a profit goal – and pay for trailing stop-losses, even if it means sacrificing some profits.
4. Stocks always win in the long run
Various claims are made for the long-term average return on stocks, usually in studies that track back for more than a century. The trouble is, none of us can stay invested forever – we might have, say, a maximum 40-year window before the money is needed to fund a pension.
If you're saving for something like school fees, it's probably a lot less. And stocks don't always deliver over those timescales. Anyone who tracked the FTSE over the course of New Labour's period in office would have made next to no capital gains, and maybe an average of 2%-3% as dividends. As Cliff D'Arcy points out on Motley Fool, US investors would have done better in bonds than in shares for the 40 years between 1969 and 2009. That's not to say that you shouldn't ever invest in stocks again. But don't kid yourself that 'buy and hold forever' is a sure route to a wealthy retirement.
5. Buy what you know
Brand names are powerful. They're the reason we pay more for labelled goods – from cornflakes to training shoes – than for the non-branded equivalent. But a big brand name can also lead us to overpay for shares that don't deliver. Take a big name such as Vodafone – its share price has fallen in half over the past decade.
Sure, plenty of top names from Tesco to Apple have done nicely in share-price terms too. But as the father of value investing, Ben Graham, once observed, the trick is not just to buy good firms, but to buy them when they're cheap. Often that's when they're still relatively unknown. As Jim Slater once observed, "elephants don't gallop". So the small- to mid-cap sectors are often the places to look for the next high flyers. It might take a bit more legwork to research them, but you're also more likely to get a decent pay off.
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