Investors often underperform by following investing strategies that are based on perception rather than long-term research or reality. Even though there have been many studies showing what does work, several stock investing myths continue to exist. Understanding and avoiding these myths can make a substantial difference in wealth over your lifetime.
Strong revenue and earnings growth attract attention. This is particularly the case for companies operating in emerging industries or selling innovative products and services. Such growth makes for great news stories and everybody likes a winner. Therefore, it only stands to reason that soaring growth should lead to soaring stock prices.
The reality is different. Long-term data published in the 2013 Ibbotson SBBI Classic Yearbook (a compendium of historical data on stock and bond performance) shows that value beats growth. Over the period from 1928 through 2012, a portfolio invested in large-cap growth stocks realized an annualized return of 8.8%. Over the same period, a portfolio invested in large-cap value stocks realized an annualized return of 11.0%. If the difference does not seem like much, consider that in just 10 years, your brokerage account balance would be more than 22% larger by investing in value stocks than growth stocks. And as you keep investing, the gap becomes even larger.
There is a very simple reason why value works better than growth: Expectations tend to be higher for growth stocks and higher expectations lead to more opportunity for disappointment. When a company is doing well, investors expect it to continue to doing well. As strong rates of revenue and earnings growth are sustained, more investors buy the stock and the valuation rises. Eventually, the company reports sales and earnings that don’t meet expectations and the stock price plunges. It doesn’t matter how strong the actual rate of growth is; if the rate of growth is slower than what investors were expecting, the stock’s price will fall.
Logic would seem to dictate that good companies should make for good investments, but the two can be very different. A company can have a charismatic CEO and a great product, but little to no profitability and a business model that consumes, rather than generates, cash. A company can also be very successful and have a stock with a high valuation because of its success.
If you hear or see a company that is doing well, conduct a thorough analysis before buying the stock. Check the financials to see how fiscally sound the company is and whether profits are growing. Then look at the stock’s valuation to see if it is cheaply valued, fairly valued or expensive. You may identify a good company whose story has not gotten out in the investment community or you may find out that the company (or its stock) isn’t as good as the products you admire. The key points to remember are that a good company can be a bad investment and that all stocks are only attractive up to a certain price.
The investment media focuses on stocks belonging to the Dow Jones industrial average or the S&P 500 index. This makes sense since these are the most widely held and familiar companies. Yet the entire S&P 500 accounts for just 10% of all U.S. exchange-listed stocks.
There are many stocks outside of the large-cap index that can make good investments. As an individual, you are not tied to an investment objective that restricts you to only buying large-cap stocks, so take advantage of your freedom. Plus, as you go down in company size, the potential returns go higher. Since 1926, small-cap stocks have outperformed large-cap stocks with an annualized return of 11.9% versus 9.8%, respectively, according to the 2013 Ibbotson SBBI Classic Yearbook. Smaller companies tend to be overlooked more, and therefore their stocks have a greater chance of being underpriced. Just understand that smaller-cap stocks are subject to more price volatility and will have lower levels of trading volume, so there is a trade-off for the higher level of returns.
It only takes a $2 increase for a stock trading at $2 per share to double in price. A $20 increase is required for a stock trading at $20 to double in price, however. So, it’s easier to make money with the $2 stock, right?
Answering “yes” ignores a very basic investing concept: In order for a stock price to double in value, the company’s entire market capitalization also has to double in value (assuming no change in the number of shares outstanding). This is because market capitalization—the value of the entire company—is determined by multiplying the number of shares outstanding by the current share price. This simple formula explains why it doesn’t matter if a stock trades for $2 or $20, investors have to believe the entire company is worth twice as much as its current value in order for a stock’s price to double.
You should also ask why a stock is trading for less than the price of a basic cup of coffee. A stock trading for $2 per share or less does so because investors perceive a high level of risk. Such companies usually are not traded on the exchanges and do not regularly file quarterly reports with the Securities and Exchange Commission. It is also not unusual to incur difficulty accessing what should be easily accessible pertinent financial information.
When a stock’s price falls below its purchase price, some investors rationalize to themselves that they haven’t lost anything because they haven’t sold the stock. This line of thinking is wrong because stocks are liquid assets, meaning they can be sold (liquidated) quickly, and are “marked-to-market” throughout the trading day. Therefore, a stock is only worth what it is currently trading at.
Put another way, you lose purchasing power when a stock falls in value. If you invest $5,000 in a stock and the price falls by 20%, your investment is now worth $4,000. Whatever you were planning to do with the money, you now have 20% less to spend than you did before. Not only have you lost purchasing power (you can buy less stuff with the proceeds of your investment), you have also incurred opportunity costs (the loss of the value you would have received by doing something else with your money.)
This does not mean you should be quick to sell a stock whenever its price drops. The market ebbs and flows, and you will have losses. Even the most successful investors incur several losses over their lifetimes. What it does mean is that you should never hold onto a stock for the primary purpose of trying to get back to breakeven. Re-examine the company’s prospects and the reason you bought the investment in the first place. If you didn’t own the stock currently, would you buy it now over another stock that also meets your investment criteria? The answer may help guide your decisions.
Every morning, the media and investment websites discuss the stocks making headlines. Typically, these are stocks moving in reaction to an event, such as an earnings release, a new product announcement or an analyst upgrade. The reports make it sound like many people either own or are buying the stock.
But by the time you hear the news, it has already been disseminated. Professional trading organizations react to the news immediately and will price in any changes in the stock faster than you can log into your brokerage account, much less place a trade. This is why trying to react to the day’s headlines is a losing game. You simply cannot beat professional traders at their own game.
What you can do is go around them. If a stock is making headlines with good news, take your time to analyze the stock and look for a good entry price. Then plan on holding onto the stock for an extended period, eyeing the valuation, the business, the financial statements and other pertinent factors. Unlike a professional, you don’t have to report your performance to anyone, so you can patiently invest and hold onto your stocks.
There is also another reason not to be reactive to the headlines. Research by Yale professor Roger Ibbotson shows that stocks with less relative trading volume tend to perform better. The reason is simple: Since there is less focus on them, these stocks are more likely to be mispriced and therefore undervalued. So, consider looking at the stocks that aren’t making the headlines for potential investment ideas.
Dividend stocks are often perceived as stable, slower growth companies. As such, growth investors may view them as boring and not capable of delivering high returns.
Yet the reality is far different. Research from Ned Davis Research Inc. finds that dividend-paying stocks deliver higher total returns than non-dividend payers. During the period of January 31, 1972, through January 31, 2013, stocks of companies that either initiated or increased their dividends realized annualized returns of 9.7%. During the same period, stocks of companies that didn’t pay dividends returned 1.8%. On an initial $1,000 investment, this difference equates to a $42,000 increase in wealth for buying dividend-paying stocks.
A great deal of marketing dollars is spent promoting concepts designed to convince investors they can beat the market. The data suggests otherwise. Out of the 258 large-cap mutual funds with 10-year return histories covered in our “Guide to the Top Mutual Funds” (AAII Journal, February 2013), 56% failed to beat the return on the S&P 500. These are funds run by professionals who graduated from top-notch business schools with teams of analysts and access to research, economists and corporate executives. (AAII’s current “Guide to the Top Funds” can be accessed here.)
Compounding matters are common behavioral errors made by investors. Research firm DALBAR calculates that the average return actually realized by mutual fund investors is less than half that of the S&P 500. Blame a combination of buying and selling at the wrong times.
This not to say you can’t make money selecting individual stocks. Even Warren Buffett says those who have the time and inclination to select stocks can do well. The key is to approach investing in a disciplined, rational manner with a focus on what research shows has worked over the long term, and not falling for the myths that trip up so many investors.