4 Myths and Clichés that Will Hurt Your Trading
The financial markets love pithy sayings to convey complex ideas. Many of these get reflected in mainstream commentary. Some are useful but not all. And there are many sayings and commonly held beliefs around investing that are simply wrong and should be dismissed. Here are some that you should avoid.
A share of common stock is ownership in a company. It entitles the holder to a claim on assets as well as a fraction of the profits that the company generates. There are many variables involved but, over the long term, a company is only worth the present value of the profits it will make. In the short term a company can survive without profits because of the expectations of future earnings, but eventually a company's stock price can be expected to show the true value of the firm.
A future is a contract for ownership of a physical product. Commodity contracts are worth the value of the commodity based on its use value in the real economy. Gambling, on the contrary, is a zero-sum game. It merely takes money from a loser and gives it to a winner. No value is ever created.
Sometimes there is a clear reason why a market has moved, but not always. Markets fluctuate. Either way, what does it benefit you to put effort into knowing why a market rose or fell on any particular day? Usually there is no benefit. It’s much better to just accept that a price changed and act accordingly.
True if you are willing to wait long enough, but the long term can be very long indeed. If you had bought shares before the Wall Street crash it would have taken about 25 years for them to recover from a 90% loss. If you bought in the mid-1960s you would have waited until the mid-1980s to see a profit. And the market was lower in early 2013 than it had been in the late 1990s. Timing is important with a buy and hold strategy just like other approaches.
Whatever the reason for this myth's appeal, nothing is more destructive to amateur investors than thinking that a stock trading near a 52-week low is a good buy. Think of this in terms of the old Wall Street adage, that traders who try to catch a falling knife only get hurt. Price is only one input to your decision. Buying simply because a market price has fallen will get you nowhere.
The laws of physics do not apply in the stock market. There is no gravitational force that pulls stocks back to even. It’s not that stocks never undergo a correction. The point is that there is no reason the stock price of a great firm run by excellent managers won't keep on going up.
There is an insurmountable problem with this approach. You never know what is meant by low in advance. You can only see it well after the event. Is a price today that is below yesterday’s a low price? If it goes even lower tomorrow then today’s price will look high. Buy Low, Sell High might explain how a fortune was amassed but it is of no use as a strategy. Buy at the market price and sell at a higher market price is the real objective. You can observe the market price in real time. The required skill is to find stocks that will have a higher price in the future.
Technical analysis is just the analysis of charts and data related to how a market is performing. There’s nothing unique to the markets in this as such processes are used regularly throughout business. Indicators are just statistics to help clarify the data. The chart is just an accurate representation of what has happened. It does not tell you what is about to happen. But if patterns are recognised over time then it is reasonable to assume that such patterns are likely to continue to appear as these patterns represent the actions of market participants in different situations. People don’t change and so they are likely to continue to act and react in similar ways. Therefore the interpretation of a chart pattern is just a conclusion that one thing has a slightly better chance of occurring than an alternative. That’s enough to give you an edge.
If this were the case then good news about a company would lead to a price rise. But the reverse is often the case as even good news might not be as good as expected. Expectations are not fundamentals and as long as positive expectations continue then a stock can continue to rise. It’s the perception of fundamentals that matters, not the actual numbers themselves.
Although many claim to be able to call every market turn, the fact is you cannot predict what the market will do next. So individuals know as much about what will happen as do the experts. In any case, with the internet, pretty much all the data and research tools that were previously available only to insiders are now available for individuals to use. Many actually contend that individuals have an advantage over institutional investors. Big money managers are under extreme pressure to get high returns every quarter. Their performance is often so scrutinized that they can't invest in opportunities that take some time to develop. Individuals have the ability to look beyond temporary downturns in favor of a long-term outlook.
Unfortunately you can. You will only be right on perhaps 35 to 40% of you investments. So you must make a large enough profit on these to pay for the 65% on which you lose. Taking small profits may be a poor strategy. What many do not realise is that finding good exits is at least as important as finding good entry points when trading.
A paper loss exists when you would lose on an investment if you closed out the position but you have decided not to do so. The danger is that by not recognising this as a loss you have an incentive to hold on to the investment. This means that a small paper loss can become a big paper loss and eventually a big realised loss. This is the worst possible outcome.
High dividend stocks may look good as they will be paying a yield well above the interest rate. But why is the market priced at a level to require such a premium? The answer is that there is risk and the risk adjusted return from such stocks is no higher than what would be available elsewhere. Why should you wish to take on such additional risks?