(This article is a part of the series aimed at dispelling some of the popular financial myths. Please refer to the full index for myths related to other financial topics. Oh, and a quick disclaimer: I am not a financial advisor. I have made every effort to research the facts before presenting them here. But, if you have a reason to believe any of the statements are incorrect, please feel free to correct me.)
- Myth: “You can expect to earn around 10.7% on your investment in the stock market since this is the average long-term returns so far.”
- Myth: “To begin investing, I need to accumulate a lot of money first.” (Variation: “I cannot afford to invest”).
- Myth: “I can beat the stock market.” (Variation: “I should invest with a fund manager since fund managers know how to beat the stock market.”)
- Myth: “Timing your transactions is very important in order to succeed in the stock market.”
- Myth: “I should leave investing to the pros’ since I don’t have enough time to follow the market.”
- Myth: “Buying stock is like buying a lottery ticket.”
- Myth: “What goes up must come down.” (Alternately, “what comes down must go up.”)
- Myth: “If you are young, invest in the stock market. If you are old, invest in the bond market.”
- Myth: “As an individual investor I do not have access to all the information available to a broker or fund manager”
- Myth: “A stock that pays out a dividend of $10 is always better than the one that pays out $2.”
I had not realized this was a myth until I read this article titled the great stock market myth! The premise of the argument made in this article is that the source of the popular number 10.7% is the measurement made over a very long period of 76 years – 1926 through 2001. Since most of us will not invest for such a long time and 10 or 20 years is a more realistic number, looking at the same 76 in chunks of 10 years or 20 years will remove the long term averaging and reveal highly varying averages. Quoting from the article – “If you break the 76 years from 1925 through 2001 into rolling 20-year periods, you get 57 periods. Of those, 22 had average annualized returns of less than 10.7 percent. Returns for the lowest 20-year period were 3.1 percent; the highest was 17.9 percent.” So how much you can expect to make from the stock market? That depends on when you start investing and in what direction the market is headed during the period for which you invest.
I have to admit I used to believe in this myth too! But the truth is, you can start investing with as little as $20 per month. As long as you make the commitment of doing this every month and stick with your commitment, you will be surprised at how much balance you will have after a while! For example, say at the age of 20 you start investing $20 per month and earn an annual interest rate of 10%. You will have over $188,353 in your account by the time you retire at the age of 65. Yes, just giving up one evening out per month can go a long way in plumping up your nest egg. One way to invest money in small amounts is through DRIP investing. This Fool.com article has more information about DRIP investments and details how to invest small amounts of money every month. Watch out for fees though, which can seriously corrode away the earnings. And remember that this is a long term plan and you cannot expect to get rich overnight!
The stock market is quite unpredictable and there is no magic crystal ball to foresee exactly what will happen next. As a result, it is difficult for anyone – be it an amateur investor or a hotshot fund manager – to consistently beat the market. Quoting from this article, “In 2003, when the bull market began, 61 percent of actively managed funds specializing in American stocks beat the return of the Standard & Poor's 500-stock index, according to the research firm Morningstar. The following two years produced similar results, but in 2006 the figure plunged to 32 percent. […] But there are enough other factors for some analysts and financial planners to conclude that last year is the rule, not the exception.” The general perception is that in the long run 75% of the time actively managed funds will fail to beat the market. If the manager of a mutual fund, whose job it is to track the ups and downs, cannot consistently beat the market, what makes you so different?
Nothing could be farther from the truth! John Bogle, founder of the Vanguard Group, supposedly wrote: "After nearly fifty years in the business, I do not know of anybody who has done it [market timing] successfully and consistently. I do not even know anybody who knows anybody who has done it successfully and consistently." Need I say more? If you are not yet convinced, check out this list of several studies that show how harmful market timing has historically proven to be. Here is an example quote from that article - “MARKET TIMING: (1999) An Individual Investor article on Market Timing noted that a major timer- Merriman Asset Allocation fund- has returned an average of 10.8% annually for the last three years while the S&P earned 25.4%. Vanguard's funds did 21.4% without timing.”
This is where index investing comes into picture! An index fund is essentially a collection of stocks that aims to replicate the fluctuations of an index of a particular financial market. Since Index funds aim to track the market, you will receive similar returns as the index that your fund tracks, and hence *you* do not have follow the market too closely. Also, since you do not have to pay fund managers to pick the stocks that make up the fund you can save quite a bit on fees as well. Paul Merriman at fundadvice.com wrote a nice article titled 10 reasons I like index funds that is definitely worth reading. And if you want to get started on index investing this investopedia primer is a good place to start.
When you go out and buy a lottery ticket, all you receive in return is “hope”. There are not solid assets to backup this “hope”. However, when you buy shares in a company, you actually own a piece of the company. As an owner of this piece, you are entitled to a portion of the profits after all the stake holders (employees, raw materials, utility costs, marketing costs, interest on loans etc) are paid off. So if you do your research well and purchase shares of companies that have a good potential to turn a profit, then buying stocks is nowhere like gambling. Yes, there is an amount of risk and the returns are not guaranteed, but if you make your purchase decisions based on good research then you stand a good chance of making tidy profit on your investment.
They say a picture speaks a thousand words – so let’s tackle this one with a picture shall we? Here is the chart for Berkshire Hathaway class A stock (Source: Yahoo finance).
Note the logarithmic scale on the Y-axis. Currently the stock trades for $110,000 a piece! Of course this is not likely to be the norm with most common stock, but it does bust the myth that what goes up must come down. The stock market is not subject to the laws of Physics. Rather it is all about how the company is managed and what the investors perceive the value of the stock to be. By picking the right company, you could potentially ride the up wave for a long time. By picking a loser, you could wait and wait and never get out of the rut.
While generally true, this is not advice that you should follow blindly. If you are a young person saving for your retirement and can leave your funds in the market for a long time, then by all means, you should invest in the stock market. Push comes to shove, if there is a 40% decline in one year, then by sitting tight for a few years you can wait for the market to bounce back. But that won't be the case for people close to retirement. That said, retirement is not the only thing that is on your mind if you are still young and starting out. Maybe you want to save to for a house down payment that will be needed within a few years down the line. In such a case, stock market is not the place to be, no matter how young you are. Rather than looking at whether you should invest in the stock market based on how old you are, you should look at how soon you may have to take the money out and what is your risk tolerance based on the station of life you are in.
The fact that a company is “publicly” traded means that they *must* make all the information available publicly through quarterly report, annual reports, prospectus, investor guidance etc. With the proliferation of online trading sites, it has never been easier to get access to this public information. In addition, you can subscribe to a zillion news letters and feeds that provide expert analysis on how to interpret these reports. If all else fails you can call the company directly. Peter Lynch, the famous manager of the Magellan Fund at Fidelity Investment wrote the following in his book One up on Wall Street: “Professionals call companies all the time, yet amateurs never think of it. If you have specific questions, the investor relations office is a good place to get some answers. […] If it’s a small outfit, you may find yourself talking to the president.” More often than not, this myth is just a flimsy excuse for not doing the home work.
Let’s say that stock A pays out a dividend of $10. Also, suppose that the share price of stock A is $100. If you invest $10,000 in stock A, you will hold 100 shares and so when the dividends are paid out, you will make $1,000. Now consider the stock B which pays out a dividend of $2. Suppose its share price is $10. Then, for the same $10,000, you hold 1000 shares of stock B, and so when dividends are paid out, you will make $2,000. I admit that the numbers here are completely hokey, but I hope I did get the point across – when comparing two dividend stocks, the dividend payouts should first be converted into a percentage of the stock price (10% for stock A and 20% for stock B) to get a better idea of the value it provides.
There are many, many more myths associated with investing. Unfortunately, I do not feel qualified enough to delve into the more advanced topics. I would like to thank Sun from The Sun’s Financial Diary for his help in writing this article. If you are an expert in the area of investing (individual stocks, ETFs, Real estate, etc), and would like to contribute a guest post about the related myths, it will be much appreciated. I will highlight it here as an individual post and also include it in the full index (that I will get around to creating one of these days).
Anyway, stay tuned for more myth busting – I have several more topics to go through. Once the series is complete, you should be able to access the full list of myths via this index.