The stock market isn’t a hard thing to read, follow and understand. It does, however, require that investors spend some time honing those skills.
That learning curve trips up so, so many people.
So, in the absence of understanding, myths and superstitions flourish. That’s why fad diets catch on and that’s why misinformation about stock market investing endures.
Let’s break that spell.
If you’re a VectorVest customer, you have the tools in your hands right now to make market forces legible and understandable. Now, let’s take that understanding and expose five of the most common myths people have about investing.
1. Price-to-Earnings Ratios Tell You Nothing About a Stock’s Value
In many cases, P/E ratios are red herrings. They look and smell like clues about a stock’s value, but really they just throw you off the scent.
To understand why, you must understand what a price-to-earning ratio is actually telling you. This indicator only measures a stock’s price against the company’s earnings. Stock price and company earnings tell you something about a stock’s value, but they don’t paint a full picture.
So, by combining those two points into a single ratio, you risk further diluting your understanding of a stock’s intrinsic value.
“Using the P/E ratio is like trying to estimate the weight of a person by looking at their shadow,” Shawn Allen at InvestorsFriend wrote years ago. “It only works if you start factoring in the angle of the sun and you need to estimate how fat the person is, which may not be apparent from the shadow.”
A better ratio would be one that compares value to price, but then that begs the question of how one calculates value. That’s a can of worms too big for this post. For now, just understand that even professional traders are guilty of treating P/E ratios as actionable information — and they very often lose money as a result.
2. Consistent, Predictable Earnings Beat High-Risk Stocks Over the Long Haul
Whenever traders throw around phrases like “There’s no reward without risk,” they’re mostly mythologizing their own irresponsible trading behavior as something heroic.
There is ample historical evidence that people build wealth via the stock market through disciplined investing over a long period of time, not by placing all their money on a high-risk bet.
In fact, investing money in stable, expertly managed companies that reliably make money quarter after quarter is probably the safest way for most people to build wealth.
So, how do you identify these safe stocks? Look for these two criteria:
- They show consistent and predictable earnings growth.
- The earnings growth rate is greater than the sum of inflation rates plus interest rates.
We will explore the role of inflation in just a moment. For now, it’s important to understand that disciplined, rules-based trading plus market exposure over time work together to shore up risk. By following a handful of simple rules, you reap the benefits of stable, money-making stocks without taking on high risk.
Those rules include:
- Don’t let any one stock account for more than 10% of your portfolio. Also, don’t own more than two stocks in the same industry.
- Be patient. Don’t go all in with your money. Spread your investments out over time.
- Learn how to place stop-sell orders. These are actions you can program into your strategy ahead of time to limit your downside exposure.
With your position fortified, you can then let time-in-market work its magic. If you’ve found a stock with an earnings growth rate of 14% per year, you stand a good chance of doubling your money after five years.
Unfortunately, many investors let emotions and bad advice derail their strategies long before their investments make that kind of money.
3. Buy When a Stock’s Price is Rising, Not Falling
Because of some fundamental misunderstandings, many investors translate “buy low, sell high” into “buy when the price is falling, sell when the price is rising.” You can imagine how problematic that strategy is for the portfolios.
Instead, what these investors should be doing is buying stocks whose prices are rising. If that means buying at the very ground floor of a stock’s support levels before it takes off, great! But that can also mean buying a stock when it’s broken through an all-time high.
Is that sacrilege? Not at all. To see why, you need to understand that investing is all about calculating a stock’s value, not examining its relative price. So, don’t worry too much whether a stock is up 5% from the previous day. Instead, think about what gives it intrinsic value.
Investor’s Business Daily explains what those factors could be:
- Solid earnings and sales growth figures
- A pending product launch that has buyers excited
- “Sweet margins and return on equity”
- News that institutional investors are buying
Those could all indicate that a stock’s price will continue an upward trajectory, regardless of whether it’s broken through all-time highs. IBD points to Apple and Intuitive Surgical as two companies whose stocks hit all-time highs, then kept going (to the delight of investors who kept holding).
4. Don’t Use Stocks to Hedge Against Inflation
The stock market has a complicated relationship with inflation.
Stocks have long been pitched as an inflation hedge, but the only true hedges are assets that appreciate against inflation. Stocks don’t always do that, for two reasons:
- Inflation causes interest rates to go up, which is a cue for some investors to pull money from the stock market and move it into high interest rate bonds. Stocks go down as a result.
- Inflation also increases the cost of doing business, so company earnings sometimes take a hit as a result.
That said, smart investors can weather inflationary pressures by knowing where to put their money. This goes back to point No. 2 about safe stocks. Recall that a safe stock shows an earnings growth rate that is at least equal to, if not higher than, inflation rates + interest rates.
In other words, your goal is to outpace inflation with your investments, not hedge against it. Stocks can provide a way to make money faster than inflation can erode your money’s value — if you are diligent and disciplined as an investor.
5. Ignore Advice About Age and Risk Tolerance
Conventional wisdom tells investors to rein in risk as they get older. The flipside of that advice is younger investors should take on risk, and there’s maybe no more pernicious myth out there.
This goes back to point No. 2 again: Investors don’t need to take high-risk gambles with their money at any age. Teaching young investors otherwise is to set them up for a lifetime of financial woes. What’s more, they’re likely the most cash-strapped group of investors. They’re in the middle of building careers, starting families, buying homes — the last thing they need to be doing is taking on financial risks.
What young investors have more of, however, is time. And as we’ve seen, time-in-market is what makes people money. Patience pays off in the market no matter your age, but younger investors have more opportunities to reap the bounties of patience.