Chapter 1: Replacing Our Stock Market Myths
Contents
In the Introduction to Five Minute Investing, I mentioned that the ideas and approaches developed in this book would be unorthodox. In this chapter, I hope to point out and correct a few of the popular myths that abound in regard to stock investing. There are many more that exist, of course, but I’ve attempted to identify and address the most destructive ones. Please study this chapter carefully, and feel free to test any of the assertions I make in the laboratory of the market. Debunking these myths and replacing them with concepts that are closer to the truth is foundational to understanding the rest of the book.
Myth #1: The stock market is a form of gambling
Perhaps at the heart of many other stock market myths is the idea that investing in stocks is a form of gambling. Remarkably, I recently heard someone who was introduced as an “economist” say as much on a national radio news broadcast! As of this writing (1995), some of this myth has been dispelled by the relatively steady returns enjoyed by investors is recent years, versus the up and down markets experienced during the 1970s. Still, many folks consider stock investing to be fundamentally different than investing in bonds, certificates of deposit, and other more-predictable investments.
To understand why stock investing is inherently different than gambling, first we need to review what common stocks are. In the most basic terms, a share of common stock entitles the owner of that share to a fraction of what is left over after all other stakeholders in a business have been paid. So, the firm takes in revenue from customers in return for the firm’s product, and with that revenue pays for raw materials, employee wages, energy, supplies, and pays interest on borrowed funds. Whatever is left over, if anything, belongs to the holders of the firm’s stock, who are essentially the owners of the firm. Depending on business conditions and how well the company is managed, the amount left over for the shareholders can be very large, very small, or even negative.
It is obvious that the common shareholders see more variability (risk) in what they take home than bondholders, raw material suppliers, employees or anyone else involved in the operation of the firm. The common shareholder stands last in line to be paid, and because of this additional risk the shareholder demands a higher expected return than does the bondholder. In the stock market, investors are constantly trying to assess what will be left over for the shareholders both now and in the future. This is why stock prices fluctuate – because the outlook for business conditions are always changing, and what will be left over for the owners of a particular firm is always changing too. But, one thing is for sure: common shareholders expect their returns to be volatile, but they also expect them to be positive and permanent over the long run – and higher than the return on bonds, treasury bills, or other less risky investments. That is, the shareholders don’t expect to give up all their gains – despite the fluctuations in value, the returns at some point become permanent. For as long as common stocks have existed (hundreds of years), this expectation has been met: Stocks have had their ups and downs, but have trended steadily higher in value over the years. And, they have increased in value at a faster pace, on average, than dollars invested in more predictable vehicles such as bonds or treasury bills.
It is this steady upward progression in the value of stocks that sets them apart from gambling in a major way. You could buy a set of stocks, and hold them for the rest of your life. Although they would fluctuate in value over your lifetime, chances are they would greatly increase in value during that period of time. However, no other person would have lost money simply because your portfolio of stocks gained in value. This is not true with gambling. In gambling, every dollar won is a dollar lost by someone else. It must be this way because gambling produces nothing, creates nothing, and therefore can only return to a winner what it took from a loser. The value of common stocks increases without taking wealth away from anyone; in fact when the stock prices increase, the amount of aggregate wealth increases for society as a whole. This is because common stockholders do produce something: They postpone the consumption of goods (ie, they save some portion of their income ) in order to supply the seed capital needed to buy production equipment and produce goods. They get the ball rolling, so to speak, for firms wishing to produce goods.
Here is another fact which highlights the vast differences between gambling and stock investing: When gambling, the longer you stay at the gaming tables, the more likely you are to walk away a loser. In the stock market, the longer you stay at it the better chance you have of coming away a winner. In fact, if you buy and hold a well-diversified portfolio of stocks, you are virtually assured of making money eventually. Of course, many people do lose money in stocks, but only because they fritter their capital away with excessive or ill-founded trading strategies.
Every stock investor needs to know why investing and gambling are two totally different pursuits. Once you realize this, it will give you confidence in pursuing a long-term plan for investing and will make you less prone to the destructive forces of fear and greed.
So, the two facts to retain regarding myth #1 are as follows:
Gambling transfers wealth from a winner to a loser because it produces nothing. Investing increases overall wealth because the capital invested in stocks provides the initial funding for firms which exist for the purpose to producing goods and services.
The value of stocks trends steadily upward over time. They do not seesaw back and forth in the same range forever. In the aggregate, stock investors demand and receive a return that is substantial and permanent.
Myth #2: Stock Market Predictions are the Key to Successful Investing
One of the greatest popular myths about investing in stocks is that in order to be successful, you must be able to predict the stock market’s movements. Why do people assume this? For some, it is because they do not understand that stocks give a positive and substantial return over time – they falsely assume that stocks bounce around in the same range forever, and they therefore conclude they must predict movements in order to be able to sell at the top of the range and buy at the bottom of the range. For others, the desire to predict is borne out of human nature, which puts a premium on certainty. We love to know what will happen in advance. Hence, it is usually assumed by the beginning investor that to be successful, one must first become an expert at forecasting future market trends. Experienced investors know, in fact, that nothing could be further from the truth.
Some icons of Wall Street love to advance the cause of market predicting, because they are paid to predict these movements. Others simply humor their clients who are looking for market projections because they know that it is easier to give them a projection than to try to correct the clients’ thinking. For instance, nearly every retail brokerage firm has a chief economist or market strategist whose main responsibility is to predict the climate for stocks. A large number of books, advisory services, and such that are sold focus themselves almost exclusively on prediction of how the stock market in general will perform in the future. But in truth, the best way to make money in the stock market is to avoid approaches that rely on market predictions. This will most likely seem an odd or even a absurd statement to some, perhaps most. Yet, any serious review of the results of market gurus over a long period of time reveals a track record that is no better (usually worse than) a simple buy-and-hold strategy.
Don’t misunderstand me: There is no doubt that if a person could accurately predict the short-term fluctuations of the stock market, that person could far exceed the return of someone who simply bought a basket of stocks and sat on them. However, the one fatal problem with this is that there has never been a single person who has figured out how to do it. Nearly all market advisors claim to be able to call the market’s every turn, but in fact every credible study ever done on the subject has proven that these claims are invariably false. By far, most market prognosticators significantly underperform the market, despite their universal claims to the contrary. Given the large number of market gurus that now exist, the laws of statistics dictate that some of them must beat the market, out of pure luck if nothing else. However, they lack the ability to repeat this performance from one time period to another, and the group of market beaters will usually be a different group every time period that is sampled. If you could predict which guru would be right for the next year, you would be in good shape. But, of course, it’s just as hard to predict which guru (or which dart board) will be right for the coming year as it is to accurately predict market conditions. Finally, even if we are generous and assume that there is some market forecaster out there who has the holy grail of market prediction, our chances of being able to sort him out from those who simply got lucky are pretty slim.
As of this writing, the market prognosticators who are most successful over the past ten to fifteen years are those who have been perpetually bullish. Although we all get bearish once in a while, we do best when we keep our bearish feelings from affecting our actions. Therefore, I recommend that you feel free to have your opinions about where the market is heading, but always invest as though the market is going higher. Over the long run, you will be better off than if you had jumped in and out of the market. Of course, you have to exercise some caution in having an optimistic viewpoint; the best policy is to only invest money that you can afford to be patient with if the market stalls or backtracks. If you take out a huge mortgage on your home with the expectation of investing it for a quick payoff, you are tempting fate and your emotions of fear will almost certainly cause you to fail.
If results are any indication, the conclusion must be that market forecasting is prone to failure. One of the purposes of this book is to free you from the compulsion we all seem to have to predict future market trends.
An alternative mindset to the prediction game
If we are not going to spend our energies wondering where the market is going, then how can we succeed in the stock market?
The key is to develop a method which will react to events as they occur, and will ensure that our returns are as good or better than the returns on the general market, whatever those market returns may be in the future. We can essentially ignore what “the market” is doing – or especially what it is forecasted to do in the future. We own our particular set of stocks, not “the market.” What we really need is a method which concentrates on how our stocks are actually doing, as opposed to how they will do in the future. We own our portfolio of stocks. The Reverse Scale Strategy is such a method and will be developed later in this book once its theoretical underpinnings are explained.
If you just can’t help yourself…
As most investors eventually learn, market prognosticators are notoriously inaccurate. If you already know the futility of market forecasting but feel that you simply must predict the market, I will reveal at this time how you can be as good as the best market gurus in predicting the market: When you get up each and every morning for the rest of your life, make this astonishing prediction: “The market will be up today.” If you make that your prediction every single day you will be as accurate as some of the best people in the field of economics, having achieved a long-run accuracy of about 60%. Despite people’s fears of bear markets, the market spends most of its time advancing, not declining.
In the long run, a good investment strategy that doesn’t rely on prediction will beat a market forecasting strategy.
Myth #3: What goes up must come down
The statement “what goes up must come down” is certainly true in the natural world, and it’s often assumed to be true in the world of investing as well. I will attempt to convince you that this assumption will lead you to make some pretty significant strategic errors in your investing.
If you refer to the conclusion from Myth #1, you will see that in the aggregate, stocks trend upward over time and at some point, they advance to the point where they will never again return to their previous levels. As we have noted previously, stock investors demand a permanent return on their investments, just as investors in other types of assets demand a permanent return on theirs. A good high-profile example of this is the Dow Jones Industrial Average, which is now at about 5,000. In the 1930s, it was around 50. I do not expect to ever see it at 50 again. So, from here the Dow may dive to 3,000 or it may continue advancing, but there is a certain point below which it will never again dip. So, certainly the gains enjoyed by shareholders up to Dow 2,000 or so may be considered “permanent.” At some time in the future, the gains up to Dow 5,000 will also become permanent as the market will at some point dip to the 5,000 level for the last time. Naturally, there is no way to tell when that will occur.
Certainly, some individual stocks do go up rapidly, then give back the entire gain just as rapidly. All seasoned investors have had this disappointing experience. However disappointing it may be to have a good profit going and then see it evaporate, do not let this bitter experience lead you to believe in taking profits too quickly. If you do, it will cost you the really big gains, in the long run.
If you think about it, the fact that the entire stock market marches higher, often never to return, then there must of necessity be some individual stocks that also advance without returning to their previous lower price levels. In fact, this is the case more often than not. Even so, the average person commonly expresses the belief that when they have a profit going they should take the money and run – often leaving a lot of money on the table when they do.
Of course, the grain of truth in this myth is the fact that any stock trend consists of a series of advances and retreats, resulting in a net increase over time. So if you are going to believe the statement “what goes up must come down,” then keep in mind that it often happens that a stock moves way, way up, and then comes down just a little. Think of it this way: If a stock increases tenfold in value and then undergoes a 20% correction, we are still ahead by eightfold.
Given enough time, stocks of individual companies often make substantial price progress over time, and sometimes with no major pullbacks in price. As an example, following is a listing of stocks whose prices increased remarkably over a period of recent years:
| Stock | Price Move | Time Period | Percentage Gain |
|---|---|---|---|
| Fastenal | $7/8 to $38 | 1987-95 | 4,242% |
| Linear Technology | $2 1/8 to $38 | 1989-95 | 1,688% |
| Jupiter National | $3 1/2 to $27 | 1991-93 | 671% |
| Mid-Atlantic Medical Services | $2 3/8 to $27 | 1991-94 | 1,078% |
| Micron Technology | $3 to $95 | 1992-95 | 3,066% |
There are many, many others. Obviously, these are the types of stocks you want to find and hold onto. You won’t find them often, naturally, but eventually you will find them if you use the stock selection criteria in Chapter 4.
It’s educational to note that all the above listed stocks spent a lot of time on the daily new-highs list while they were increasing in value. The new-highs list is published daily in most financial newspapers. It is a list of stocks which traded above their previous high price for the past 52 weeks.
Linear Technology, as an example, hit a new 52-week high on 1/3/90, at $2 3/4. It topped out (so far as of this writing) at $45 5/8 on 11/9/95. There were 1,491 trading days between those two dates, during which Linear Tech appeared on the new-highs list 157 times, meaning it made it onto the new-highs list about once every two weeks, on average. During those 1,491 trading days, Linear Technology did not appear on the 52-week-lows list even once. Yet, incredibly, many people go to the new-lows list when prospecting for stocks! They ignore the new-highs list, assuming that the stocks listed there are “too high.” In so doing, they decrease their chances of finding the next Linear Technology from pretty good to almost nonexistent.
Just because a stock has had a large increase in price does not mean it cannot increase further. Stocks which are hitting new highs often continue making additional new highs in price.
Following is a chart of Linear Technology’s price trend from 1989 to 1995:
Once a good performing stock has been identified, don’t wait for a pullback in price before taking your position. In the long run, this will cost you more in profits than it saves in losses.
Myth #4: What goes down must come back up; or Buy low, sell high.
This myth is the granddaddy of them all. In the subject of investing, probably no more destructive misconception has ever been conceived than the idea of buying low and selling high. Whatever the reason for its appeal and widespread popularity, no myth is more pervasive among amateur investors. The emotional appeal of this myth leads investors to commit many of the most grievous errors listed in Chapter 2 on the most common investor mistakes.
Stocks make all price movements in trends. Sometimes these movements are small, sometimes huge. Given enough time, most stocks eventually have some large price trends which develop. Although most people know this, few take the time to realize the implications of it. As will be covered later in this book, one of the most common investor mistakes is to buy stocks that are “down” in price. The common assumption is that if a stock has gone from 40 to 10, it is somehow more likely to get to 40 again than is a stock that has gone from 4 to 10. They are both at 10, but the majority of novice investors assume the stock that is “down” in price will be a better bet than one that is trending upward. This is exactly the opposite of the truth!
If you are to succeed in the stock market, you simply must eradicate from your mind the appeal of buying declining stocks!
Think about this: If a stock is destined to go from 5 to 100, it of necessity must pass through 6, 7, 8, 9, 30, 50, 80 etc. to get there. It does not have to (necessarily) pass through 4, 3, 2 or 1 on its way to 100. This is why picking stocks that are trending upward in price gives you a better chance of finding timely, winning stocks than buying stocks in a declining phase. Why then, do most beginning investors tend to choose stocks that have declined in price, rather than choose ones that are at all-time highs? Simply put, because they “feel” safer buying a stock that once sold for a higher price. This false sense of security has led many investors to the poorhouse over the years.
Most investors will find it useful to study a long-term chart book in order to get a feel for how stocks make large price moves. Some good references for doing this are Long-Term Values, published by William O’Neill and Co, and the Value Line Investment Survey. As you study these long-term charts, note just how many stocks have made 300-1000% moves. You will find that such moves are not at all uncommon, and some of them happen in an almost uninterrupted manner. Sometimes, stocks will even make more stunning moves of 2000-3000% over longer periods of time. It is inevitable that any stock in an uptrend will have periods of correction (short-term pullbacks in price), but most often there are some long trends where pullbacks do not exceed 30% of the stock’s peak price.
Study the price chart of a stock that has had a large (four to ten-fold) increase in price and note carefully just how many times this stock made a new all-time or at least a 52-week price high. From this you should learn that someone who is afraid to buy (or hold onto) stocks making new highs would automatically guarantee that they will never reap the benefits of large price moves. And yet, it is only by owning these very strong stocks that the true profit potential of stock investing is realized. By studying the way in which price trends occur, you will give yourself confidence to hold onto your winners rather than succumbing to the temptation to sell your winners to ‘lock in’ profits. This is why trading strategy (or the way you manage your stock picks) is just as important as which stocks you pick.
It is impossible to reap big profits from the stock market unless you are willing to buy and hold onto stocks that are making new all-time highs in price. Further, stocks that are at new price highs tend to do better than those making new price lows.
Eventually, everyone finds stocks that will ultimately turn out to be big winners – but not everyone ends up profiting from them. It is your trading strategy that will determine whether or not you reap the benefits of the winners you find.
Valuation measures
If you are to make really big money in the stock market, resign yourself to the fact that just about everything you buy, if you are buying stocks correctly, will seem too high priced by just about any traditional measure of valuation. This is because traditional measures of a stock’s value generally are of little usefulness in circumstances where earnings are growing very quickly. Use of these measures as stock selection criteria often misleads investors into buying stocks that are declining in price. For instance, Price/Earnings (P/E) ratios are a commonly misused measure of a stock’s attractiveness as an investment. Many investors try to buy stocks that are selling for very low P/E ratios, meaning that the stock is selling for a low price relative to the previous year’s earnings. They believe that if the stock is selling at a low P/E ratio, then the stock must increase in value. This approach to selecting stocks is flawed because it assumes all companies have roughly the same future earnings growth prospects. However, the reality is that companies have vastly different outlooks for growing earnings and that is why the market rightly assigns a low P/E ratio to some stocks and a high one to others. There are companies which grow earnings at 2 to 3% per year for years and years on end. There are also companies which grow earnings at 20 to 30% per year over many years. It is absurd to assume, as proponents of a low-P/E ratio strategy do, that a company which is positioned for high growth should be priced the same as a stodgy company in a shrinking industry.
Another popular but flawed concept which leads investors into buying stocks which are declining is the practice of purchasing stocks which are selling for a low price relative to “book value.” Book value is calculated by taking the value of the assets owned by the firm and subtracting out any debts the firm may have. There are three problems associated with using this calculation as a investment screening parameter:
- Book values as calculated by accountants often bear no resemblance to the real value of assets on the balance sheet.
- Firms which are selling for a low price relative to book value are selling for a low price for a very good reason: these firms invariably are earning a very low return on their assets. After all, the value of a firm’s assets really do not matter; what matters most is what the firm can earn on those assets for their shareholders. A person looking for low prices relative to book value forgets that most firms which are earning substandard amounts on their assets generally keep on earning low rates of return.
- Much of the earning power of a firm is determined not by physical or financial assets, but instead by the abilities of the people working for the firm (human capital) and by the position of the firm in the market it serves. Book values capture none of this and thus ignore completely the most critical assets which a firm possesses.
It is best to avoid stocks that are declining in price, even if they have financial measures which appear to make them good values.
Stocks that appear to be cheap by financial measures and are falling in price tend to keep falling, and what seems too expensive and is rising in price tends to keep on rising.
Five Minute Investing Course
Introduction
Chapter 1: Replacing Our Stock Market Myths
Chapter 2: Things to Avoid
Chapter 3: Know Yourself
Chapter 4: Stock Picking
Chapter 5: How to Evaluate a Trading Strategy
Chapter 6: The World’s Worst Trading Strategy
Chapter 7: The Reverse Scale Strategy
Chapter 8: Margin Power
Chapter 9: Implementing the Reverse Scale Strategy
Chapter 10: Getting Started