5 Myths About Stock Investing

How to Avoid Faulty Assumptions About the Stock Market

Published on:
February 23, 2018
Written on:

About The Author

Noam Ganel, CFA is the founder of Pen&Paper, a value-oriented, contrary-minded journal of the financial markets. Noam worked as a Vice President in Capital Markets at Silvergate (publicly traded on NYSE under SI since Nov-2019.) At SI, which he joined in 2010, Noam was responsible for advisory services to family offices,  private companies, and financial advisors.

Myth #1: The greater the risk, the higher the return. 

 “No pain, no gain,” said Jane Fonda in one of her workout exercise videos. Somehow, the investment world has followed Jane’s advice. Today, the “obvious” relationship between risk and reward is hardly even worth the mention.

But the focus should be on the relationship between effort and return. That is, the more effort you put into analyzing companies and understanding their financial statements, the more likely that your see a higher return.

Let me restate the above paragraph in its negative form. The less effort you put into understanding the stocks you invest in, the more likely it is that you will lose money. Unfortunately, I learned this lesson the hard way. As I wrote in The Lessons Learned in Investing in Bon Ton Storesand in How Rait Financial Taught Me A Lesson, there is a price to be paid when financial information is overlooked or when notes to the financial statement are not read carefully. (You should read management's notes and disclosurelike you would read a lover letter: where you never want to miss a word).       

Myth correction: There is a relationship between how much effort you put into stock research and your investment results.

Myth #2: Risk is the change in a stock’s market value. 

Ask any MBA graduate how they were taught to understand risk and they will tell you that risk is the change in the quoted market price of a stock. For example, if the market price of stock A ranged between $17 and $20 while the market value of stock B ranged between $20 to $10, then stock B is riskier than stock A. But I propose to view risk as simply the likelihood of losing money.

Here is a thought-game to illustrate the idea. Meet George, who recently purchased a home. George is likely to sell his home in two years due to a job relocation. Now meet Benjamin, the proud owner of a home nearby. But, as opposed to George’s situation, Benjamin owns a dentistry practice near his home. And Benjamin intends to live in that home for at least another decade. It should be obvious to you that George has taken a substantially greater risk and is exposed to changes in the real estate market.  

Myth correction: The definition of risk is how likely it is that you will lose money.

Myth #3: Future growth is more important than current price.

 Investment advisors (spoiler alert: the topic of the next myth) often reason a hefty premium on earnings, say, anything above 25 times last year’s earnings per share, with the rationale that future growth in earnings will justify the current premium paid. And the great investing gurus have often stuck to that logic which further supports the myth. But for many of us it is the short term that dictates our investing behavior.   

Take Goodyear Tire & Rubber Company as an example. Let us say that you had bought the stock in 2007 and had paid as low as $21 or as high as $37. Prior to your purchase, the company had shown earnings in five of the seven prior years. But the largest U.S. manufacturer of tires reported losses in both 2008, 2009 and 2010. And if you were to sell your position in 2011, you would receive as low as $8 and as high as $18. Very few of us would be able to hold the position for another decade.

In the Intelligent Investor, Benjamin Graham described the investor and his “short-termism:”

“His frame of mind, his hopes and apprehensions, his satisfactions or discontent with what he has done, above all his decision what to do next, are all determined not in the retrospect of a lifetime of investment but rather by his experience from year to year." 

Myth correction: current price is more important than future growth.

Myth #4: You will profit by listening to investment advisors. 

Walk down Main Street in any town in America and you will not find a single store that sells profitable business ideas. And if an entrepreneur reads this and decides to venture out and to establish such an enterprise, common sense would dictate that if the entrepreneur truly knows how to earn a profit, would he or she not attempt to profit for him or herself?

But this common sense convention - that truly profitable ideas are rarely shared - is hidden by the naiveté of investors who rely on investment advisors to help them choose stocks that will (hopefully) increase their fortunes.

(To be clear: this is not a rant against investment advisors. Many of them are professionals who assist clients in retirement planning and by preventing their clients from making dire mistakes in the stock market. That is a praiseworthy work).

Myth correction: the role of a financial adviser should be to supply information and offer suggestions. 

Myth #5: A hot stock market signals that you should sell stocks.

I will make the argument that to ignore short term market movement is one of the best decisions you will make as an investor.  As I wrote earlier this year in Why I am Doing This, my plan for 2018 is to allocate $20,000 to the U.S stock market (effectively all my expected savings). I plan to allocate $5,000 each quarter and to find one stock to invest in about once a month. For most of us, it is very difficult to be oblivious to a declining stock market, so forming habits and goals (such as investing in stocks, regardless of where the market is) is one way to handle our investing nature that often acts against us. In the words of an ancient poet, “Habit’s but long practice, and this becomes men’s nature in the end.”

Myth correction: make a yearly plan of stock investing and stick to it.

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