The stock market can be an incredible tool for increasing wealth, especially over long periods of time. But making sound investing decisions is largely dependent on possessing an accurate set of beliefs. Examining some common stock market myths can help to uncover faulty thinking.
Ask yourself if you’ve believed these myths in the past. Take the time to investigate them if you’re having doubts further.
Are any of these myths hindering your investment results?
MYTH: LARGER-CAP STOCKS ARE BETTER THAN SMALL-CAPS.
Television, newspaper, and magazine pundits primarily focus on the largest stocks. We’re always hearing about Apple and General Electric. This is done to make the information relatable to the average armchair investor. We’ve all heard of Microsoft.
The most famous investors in the world also focus on larger stocks, but this is out of necessity. They have so much money that they have little choice. Warren Buffett has hundreds of billions of dollars to invest. A small-cap stock simply won’t work for him. There’s simply too much
money to invest in that way.
Avoid limiting your options and remain open to all investing opportunities. From 1926 to today, small-cap stocks have beaten large-cap stocks by 11.9% vs. 9.8% in annual return.
‣ MYTH: THE S&P 500 IS EASY TO BEAT.
If you don’t have much time to put into your investing efforts, an index fund is difficult to beat. Very few non-index mutual funds manage to beat the market on a regular basis and professionals manage these funds!
Over time, the average, non-index mutual fund investor earns less than half the return of the S&P 500.
If you don’t have the time to immerse yourself in managing your investments to eke out every cent of possible profits, consider an index fund.
‣ MYTH: MARKET TIMING IS A GREAT WAY TO IMPROVE RETURNS.
This would actually be true if it were possible to do it successfully. Unfortunately, this rarely occurs.
‣ MYTH: THE BEST TIME TO PURCHASE A STOCK IS AFTER A DRAMATIC DROP IN PRICE.
When a stock has lost considerable value, it may or may not be a good time to buy. The fact that a stock price has fallen is not necessarily an indicator that the stock can’t fall further. The lowest a stock price can drop is zero!
Why did the stock drop? Is your expectation that the stock will rise justifiable? Have a good reason behind your decisions.
Similarly, a rising stock isn’t necessarily a good purchase, either! Is the stock price rising for a good reason that indicates healthy long-term profits? Should you expect the stock to continue rising?
‣ MYTH: A LITTLE KNOWLEDGE IS ENOUGH TO DO WELL IN THE STOCK MARKET.
In most things, a little knowledge beats none at all. However, in the stock market, this can be a dangerous attitude. A little knowledge can result in overconfidence, and overconfidence leads to poor decision-making.
The best amateur investors have a high level of knowledge and understanding. It’s not necessary to understand every type of company. But the average person can become an expert in a particular industry. Do your homework and you are likely to be well rewarded.
‣ MYTH: TO BE SUCCESSFUL, YOU HAVE TO TAKE YOUR PROFITS.
Many investors insist on selling and taking profits when a certain profit is attained. There are two issues with this strategy:
1. There really isn’t a limit on how high a stock can go. To take a 20% profit and run eliminates the possibility of making a 1000% profit or even more.
2. Taxes inhibit future gains. When a profit is taken, the government wants its cut. That means less money to invest in the future versus keeping that money in the same investment. There are advantages to holding stock.
‣ MYTH: HIGH DIVERSIFICATION IS IMPORTANT.
Many famous investors have commented that diversification is great if you don’t know what you’re doing. Diversification is a useful tool for minimizing losses. When certain stocks fall, others tend to rise. This is great when one of your stocks tanks.
Unfortunately, it works both ways. When certain stocks rise, others tend to fall. So profits are limited in the same way losses are limited. World-class investors have suggested that just a couple of stocks are plenty. While pouring all of your money into a single stock is foolish, over-diversifying can be foolish and limiting, too.
‣ MYTH: STOCKS ONLY DO WELL IN STRONG ECONOMIES.
It’s not necessary to be able to predict the economy to invest in the stock market successfully. Many studies have shown that there is very little correlation between economic growth and stock market performance. Avoid letting a bad economy dissuade you from being in the market.
Even during periods of recession, US stocks earn an average of almost 10%. Electing to stay out of the stock market during challenging economic times is almost surely an expensive mistake.
‣ MYTH: BONDS ARE LESS VOLATILE THAN STOCKS.
This is actually true over the short term. It’s not uncommon for a stock to lose 20% or more in a short period of time. Over long periods of time, though, bond returns are actually more volatile than stock returns! When comparing 10-year Treasuries and the S&P 500, it’s not even close. The standard deviation for treasuries has been 2.52% versus 1.58% for the S&P 500. These are 30-year rolling averages since 1928.
Over long periods of time, stock returns are significantly less volatile than bonds. If your investment horizon is long-term, focus on stock investments.
‣ MYTH: GOOD COMPANIES ALWAYS HAVE GOOD STOCKS.
Microsoft is an excellent example of this myth. The stock fell 37% between 2000 and 2013. The company definitely had its share of mistakes, but revenues increased over 3-fold, and earnings increased at 2.5 times the rate of the S&P 500.
Microsoft has done well, but the stock has performed abysmally. Microsoft was simply overvalued in 2000.
Studies have shown that the most heavily favored stocks underperform the most disliked stocks.
‣ LOOKING FORWARD
Eliminating these stock market myths will allow you to make better investing decisions. Wiser decisions lead to more profitable returns.
How many of these myths did you previously believe? Are there any that you still believe? Do your own research and verify the facts presented. Convince yourself of the truth. Change your beliefs and watch your returns improve.