WALL STREET MYTHS
INTRODUCTION
The dictionary definition of myth is “a legend or fable embodying people’s unfounded convictions; an invented story having no basis in fact.” At their best, myths bring color and depth to an otherwise mundane tale, and can transform an ordinary man simply doing his duty into an iconic hero. Such are the myths which so enrich classical Greek literature. Unfortunately, myths also constitute a substantial portion of today’s Wall Street lore, leaving investors mired in misunderstandings as to just how the stock market actually works. Taking Greek myths literally today might invite close psychiatric scrutiny but would still leave your estate intact; acting upon these long honored Wall Street fables, however, as if they were facts, could cost you dearly.
What follows is fourteen of the most widely accepted Wall Street myths, followed in each instance by the reality which, unlike the myth it replaces, does provide a true rational basis for investment decisions. Note that most of these myths are eminently plausible, enjoying the ring of common sense, greatly enhancing their hold on the minds of the investment community. But to accept them as scientifically valid – as does much of the Street – and you’ll get the same average/ mediocre results as do most investors. Seeing through these myths and on to an authentic understanding of how markets really function will give you a substantial edge, and should enable you to regularly beat the market whether it be bull or bear.
Famous Wall Street Myths
1. Myth: The stock market does best in a robust economy and poorly when the economy is in the dumps. Invest accordingly.
Reality: The market in fact does better in mediocre economies and can prosper even in a poor one, especially one just starting to recover.
2. Myth: A bear market is a bad time to purchase stocks; stocks of even highly profitable companies are bound to decline and you surely will lose money.
Reality: Bear markets are excellent hunting grounds, for it is here that the most promising stocks of the future reveal themselves. The rising tide of a bull market lifts all ships including leaky ones. By contrast, stocks which hold their own in a bear market are worth serious consideration. Bear markets help to separate the wheat from the chaff, the strong from the weak.
3. Myth: The price performance of a stock roughly parallels the value or profitability of the underlying company.
Reality: Sometimes. Mostly, no. About a third of the time the price of a stock may indeed be commensurate with the value and profitability of the company, but a third of the time the stock is overpriced, a third of the time underpriced. The “Goldilocks investment” is the purchasing of stocks in the last group as they suddenly turn upwards and/or start hitting new highs.
4. Myth: Prospective investment gains are proportionate to risk; that is, securities promising the greatest, most rapid appreciation are also the ones most likely to drop precipitously; whereas conservative, non-volatile securities that are best for preserving capital offer far less by way of capital gains.
Reality: There is no consistent relationship between profitability and risk — nor should there be. Admittedly, one can find numerous instances where the correlation appears strong, e.g., penny stocks that spring up 200% in one month and fall to near zero the next. But are Apple, Amazon, Netflix and Priceline, whose stocks have doubled in less than a year, risky, fly by night corporations?
In short, there are plenty of rock solid, reliably profitable companies whose stocks can make you a lot of money quickly with little commensurate risk of suddenly losing your investment.
To my mind, the old Wall Street adage that “an investor is entitled to greater rewards for bearing greater risk” raises several questions:
Says who?
From whom?
Whence comes this fair and equitable good fairy bearing extra rewards for the adventurous investor while callously shunning the more cautious one?
The market doesn’t know that you’ve made “a risky investment” because the market has no brain. It cannot “know” anything. Neither can it feel that you deserve a greater reward because the market has no heart (apologies to “The Wizard of Oz”). The market is not a thing, let alone a person – it is a statistic that neither thinks nor feels.
If you’re reckless enough to expose your capital to excess risk, I suppose, were life mathematically fair, there would be a big payoff — assuming that you guessed right. But why needlessly place your wealth in peril when reasoned choices made amongst that huge universe of low risk companies can also bring substantial rewards?
5. Myth: Investment vehicles fall inherently into one of three groups: (1) risky; (2) neutral; (3) safe.
Reality: Investment vehicles are not inherently anything. A security is or at least used to be (now it is likely to be virtual), residing – one hopes – in a cloud.) just a piece of paper. What may be relatively risky or safe is your investment style – how you utilize investment vehicles. (Enjoy a small plate of spaghetti with a little olive oil a couple of times a week accompanied by a glass or chianti and it’s good for you. Hoover up two pounds of spaghetti every day, washed down with a couple of bottles of wine and it’ll kill you.) So it is that you actually jeopardize your financial future if you put your retirement money into what is supposedly one of the safest investment vehicles out there – CDs, currently paying 1%, less than the current rate of inflation. Far safer would be to put that money into ten stocks – indeed, almost any ten stocks.
In short, it is how you make use of these various investment possibilities that determines your degree of risk, and not the complexion of the security itself. For example, it is far riskier investing in a particular stock that is declining than if you wait until it hits bottom and starts bouncing up – same stock, a very different element of risk, e.g., paying $10 a share for an ascending stock whose price just rose to $10 is far less risky than forking over $10 for a share of stock whose price has just dropped to $10.
A second example: Irrespective of what stocks you choose, day trading is far riskier than buy and hold. To paraphrase an old joke: Day trading is a surefire way to a small fortune, provided you started with a large one. Yes, I know, some day traders make obscene amounts of money, whereas more than a few buy and hold investors have lost their shirts. But all things being equal, the former is the far riskier approach to growing your money than the latter. In a word, it is not so much what but how you buy and sell that determines your investment’s risk/reward ratio.
An investor who works only with stodgy, somnolent Dow 30 industrials but makes dozens of trades a day faces far higher risks than one favoring penny stocks but who trades no more than a dozen times a year.
6. Myth: A long, steep rise in the market presages a correction; that is, if the market has had an uncommonly good run, it’s bound to take a 10% “breather” any day now.
Reality: Sure, an “overbought” market is more vulnerable to correction than one already “oversold.” But the thing is, the market doesn’t know whether or not its had a good run. Once again, the market cannot know anything. Ergo, even if the market’s enjoyed an uninterrupted six month climb, there is no reason why it can’t go on for a seventh, eighth or ninth month. Anyone who has seen a roulette wheel come up black a half dozen times in a row knows that every spin is a fresh new spin, and like the market, the roulette wheel has no memory. Yes, investors will be ever more inclined to take profits on those holdings that have achieved high P/E ratios but that is hardly an immutable law. In any event, nobody knows just when that will happen. My advice is to keep your portfolio intact until the correction is actually under way.
7. Myth: If a particular stock has had an great year, there’s little point in purchasing it now as most of the capital gains have been made.
Reality: The roulette wheel analogy applies here as well. Like the market as a whole, individual stocks have no memory. They don’t know if they’ve had a good year, and whatever fundamental or technical factors causing the securities to rise will continue to do so — until these factors change. An increase in the price of a stock to $10 which you just purchased for $8 is no less congenial than one jumping from $2 to $4. A $2 is a $2 profit. The rule here is not “to buy cheap and sell dear” as “to buy dear but sell more dearly.”
8. Myth: You haven’t actually taken a hit if one of your securities collapses until you sell it.
Reality: Don’t kid yourself. You’ve got a loss even if technically your account statement doesn’t yet show it. Ergo, if a once high flying stock starts to decline day after day, week after week, get out and preserve your gains – unless the stock has fallen for no good reason.
What’s a good versus a not a good reason to sell?
A good reason to sell would be, for example, that a company’s primary product has abruptly become obsolete, e.g., look what Apple did to Blackberry, Netflix to Blockbuster, Toyota to General Motors, and fracking to the coal industry. An example of a not a good reason would be, say, when some nut figured how to contaminate Johnson & Johnson’s Tylenol, two people became quite ill, and by week’s end J&J stock had lost half its value. The astute investor knows that a stock’s sudden decline for not a good reason is an ideal opportunity to buy, not sell. It will come roaring back.
Incidentally, what we here call “a good reason” for a stock to fall is usually buried in small print and footnotes. The not a good reason is typically trumpeted on the front page of the business section or even on page A1. But if you’re not sure whether the stock is dropping for a good or a not a good reason, out of an excess of caution you can always sell, then pick the stock up again after it falls and has started to turn around. (If it doesn’t turn around then you know if fell for a good reason. You were well to be done with it.)
9. Myth: The computations of Wall Street analysts bring an objective, quantitative element to predicting quarterly corporate earnings announcements and the ensuing performance of that company’s stock.
Reality: Wall Street analysts make one of the more bizarrely useless contributions to the investment world. For example:
“The wee West Coast Widget Corp. today announced a blowout quarter – in fact, the most profitable quarter in the company’s prosperous 101 year history. But earnings were a penny short of analysts’ expectations. . .” whereupon the stock takes a dump – investors unload their holdings in one of the country’s more profitable companies, perversely punishing the blameless corporation for the analysts’ misjudgment.
Obviously, management had been doing everything right. It was the analysts who got things wrong. Yet investors rushed to sell their holdings in a supremely well run corporation when instead, the analysts should be fired.
Another example:
“The Wicked Widget Corp. of the West which hasn’t turned a profit in its 101 year history, lost a penny less this quarter than analysts had predicted.” Result: investors rush in to buy this turkey.
Go figure.
Bottom line: when analysts get it wrong (again) it’s a contrarian’s delight.
10. Myth: The most gifted stock pickers make the most money.
Reality: The most money is made by the most patient stock pickers.
Happily, from time to time I have made a few shrewd, i.e., lucky buys over the years – stocks which have appreciated 50%, even 100% or more in less than a year. But when I stand back and look at the decades-long history of my portfolio as a whole, the stocks which have earned me the most are the ones I’ve bought at a discount and held the longest. It’s that simple. Thus, my edge on the S&P 500 is a function of the length of the time in which the comparison is made. I may not beat the S&P in any one individual year but if you were to, say, choose at random any three year period, my gains will exceed the appreciation of the S&P 85% of the time. Choose any five year period at random and I beat the S&P 100% of the time. As in so many other contests, the Wall Street race is won not by the hare but by the tortoise.
11. Myth: The stock market reacts to economic news.
Reality: The stock market is not a living thing and can neither read the papers nor watch T.V.
A sampling from the business pages of the New York Times should serve as an effective antidote to this myth – two headlines, both taken from Page 2 of Section B, but appearing ten days apart:
“Weak news on home sales send shares down sharply.”
“Ignoring weak home sales, Dow hits intra-day high.”
Business journalists would have you believe that the market either reacts coherently to important economic reports that day or alternatively, for reasons of its own, deliberately chooses to ignore them.
The market of course does neither. It’s anybody’s guess why the market was sharply lower one day and sharply higher ten days later – in the face of identical economic news — but clearly, tying its mysterious gyrations to home sales or car sales or the ions in the air or any lack thereof is nothing more than a fanciful rationalization. Of course, investors do not ply their trade enveloped in a complete news blackout, and will in time take economic shifts into account when making investment decisions.
Generally, the longer one’s time frame, the more one does begin to see something of a relationship between market movements and current events. Thus, I would concede that the market’s performance in any one month could well be tied to investor response to macroeconomic factors as reported in the news. On the other hand, the market’s movement during the course of any 24-hour period, indeed, during the course of a week, is very nearly random, and with rare exceptions, (e.g., a terroristic attack on the World Trade Center) exhibits movements largely unrelated to current events.
12. Myth: “Wall Street was disappointed in. . .” or “Wall Street reacted favorably to. . .”
Reality: A corollary to the preceding. Stock exchanges are buildings. Buildings can be neither pleased nor displeased, neither calm nor distressed. These fictive cause and effect headlines which populate the business pages like pimples on a teenager’s face is nothing but a journalist’s conceit.
13. By definition, bear markets are bad for investors.
Reality: Not at all. Certainly, short-term, most portfolios take a hit but this is where the perspicacious long-term investor prepares for outsized long-term gains. Remember that the most important investment rule is only purchase stocks at a discount. Such opportunities abound when most everyone else is selling – the inherent feature of a bear market. Here is where true values identify themselves. Stocks that might otherwise have been unaffordable now become available at an attractive price. The table of “new highs” shrinks to just a handful of securities – a manageable number, all of which are worthy of scrutiny and most probably, purchase.
By contrast, all bull markets eventually become a trap. At their height every investor, however inept — even mutual fund and hedge fund managers — look good. Everyone is a genius. Stocks of companies manufacturing horse and buggy goods soar. It is difficult to catch the signal of a genuine good buy in all that static.
The bear market serves to suppress that static, enabling us to identify those stocks truly worth buying.
In short, in bear markets the rabble run for cover, leaving the perspicacious investor in a peaceful, quiet place in which to reflect upon his or her purchases as well as providing a wonderful opportunity to identify the most worthy securities and obtain them at fire-sale prices. Buy only at half price and you’ll have protection from even the steepest future bear markets, preserving at least some of your gains. Best of all, you can now purchase Netflix, Google, Apple, or for that matter Visa and Mastercard at prices that prevailed three and four years ago when you wish you had bought them. Back then, the purchases seemed like a gamble. Who could have guessed these companies would have been so profitable. Now, you don’t have to guess. Scoop them up at a discount.
(By the way, you’ll note that though I welcome bear markets I do not here extol the virtues of selling short. That’s because, to profitably sell short you have to know in advance that the market or at least certain parts of it are going to head down. Unfortunately, I do not know what the market is going to do and greatly envy those with crystal balls. My meager talent is limited to knowing just what the market is now doing. But for the most part, that’s enough.)
14. Myth: A volatile market is a dangerous market. Better stay clear until it settles down
Reality: Volatility is the investor’s friend for without significant fluctuations in security prices no one could make a profit. Instead you’d have a market of CDs. Just remember that short-term, price fluctuations mean nothing – except providing the nimble investor an opportunity to scoop up valuable securities at a briefly discounted price.
15. Myth: It’s easy to make money on Wall Street – just “buy low, sell high.”
Ah, but how do you know which is which? That is, just what differentiates a high from a low price stock?
For most investors the answer is all too simplistic: a stock price is high if it exceeds what they paid for it, and low if it falls below their costs – a manifestly subjective definition if ever there be one. Thus, I might perceive a now $80 stock for which I paid $60 as rather expensive and elect to unload, whereas my neighbor, who regrettably paid $100 for the same security a while back might now see it as a bargain and an opportunity to mitigate his earlier error by buying more of it.
(I of course would be happy to sell it to him. Perhaps I’ll get to sell him a couple of options as well. This, boys and girls, is called “making a market.”)
But these subjective biases don’t end there: ideological bulls tend to see most stocks as low priced, bears as high or overpriced.
To arrive at an objective definition then, one must try to eliminate the human factor and focus exclusively on the numbers, as for example, defining as “cheap” those stocks with low price earnings ratio relative to both the stock’s past and the sector in which the company belongs. Another useful definition would be: “A cheap stock is an undervalued stock that has dropped further in price; (whereas an expensive stock is an over-valued stock that has continued to appreciate.” ) Scrutinizing the individual stocks in one’s portfolio in the context of these objective definitions provides a more rational guideline in deciding whether its price is a signal to buy or sell.
Always keep in mind, however, that as useful as these definitions may be, they do not enable anyone to predict what the market as whole or any particular stock will do. Accordingly, as we have stated many times in the past, wait until that “cheap” stock has started to recover before buying, and the overpriced stock which has made you so much money has started to fall before giving it the heave-ho.
16. Myth: One of the best devices for reducing risk is to place a stop-loss order under every stock as you make the purchase.
Reality: Yes, with momentum stocks which can collapse just as rapidly as they are ascending. But it makes no sense with value stocks where stop-loss orders can precipitously trigger you out of an evermore profitable stock just as it is taking a temporary (and inevitable) rest; more likely than not, you’ll miss the next leg up.