The Five Greatest Share Market Myths

Shares, Strategies & Common Sense

To a large degree, the investment community is its own worst enemy in scaring off the individual investor. This is very unfortunate because share investing is one of the best avenues the average person has of accumulating substantial wealth.

MYTH #1: PRICE TO EARNINGS RATIOS TELL YOU WHETHER STOCKS ARE CHEAP OR EXPENSIVE.

P/E ratios are easy to find. Just about every newspaper, magazine and share report publishes P/E ratios. Everybody seems to talk about them when discussing shares. So P/E ratios must be a great way to compare shares.

Right? Wrong!

If you were told that Fly-By-Nite Industries had a P/E of 7, and Fantastic Plastics Inc. had a P/E of 14, would you buy Fly-By-Nite Industries instead of Fantastic Plastics Inc.? You might, but you wouldn't be comfortable making that decision. Why? Because you need more information. You'd like to know a whole lot of things before you decide which share to buy. One of the most important things you'd like to know is the worth of each share based upon its earnings, profitability and other key financial data. In other words, you'd like to have a sense of the share's intrinsic value. P/E ratios don't say anything about a share's value!

What investors need is a Value to Price ratio. With a Value to Price ratio, investors would know immediately whether a share was cheap, expensive or fairly priced. But this means we have to have a way of computing value. Of course there are theories and formulas for computing intrinsic value. But they are complex, and some sophisticated investors even say they are unfathomable. Consequently, most investors, even the pros, don't begin to look at share's intrinsic value! They resort to trivial devices like comparing P/E ratios.

MYTH #2: YOU MUST ASSUME HIGH RISKS TO MAKE GOOD MONEY IN THE STOCK MARKET.

A woman recently said to me, "I'm just scared to death of shares. I can't afford to lose my hard earned money." The perception of high risk in share investing is not totally without merit. Many investors have lost substantial sums of money in the market. Visions of investors jumping out of windows back in 1929 are graphic reminders of the risk inherent in share investing.

Recent events in the market...the Great Crash of '87, the Friday the 13th Mini-meltdown, the ills of Program Trading, insider trading, the Mercury Financial and Bre-X scandals, have also contributed to the casino image associated with share investing. This is very unfortunate because share investing is one of the best ways the average person has of accumulating substantial wealth. It just requires a few simple techniques and some discipline. In fact, it can be a lot safer than investing in real estate, collectibles, or your own business.

Here's how to make good money in shares at low risk:
  • Buy shares with consistent, predictable earnings growth
  • Buy shares with earnings growth rates of at least equal to the sum of current inflation and interest rates
  • Do Not put more than 10% of your money into any single share
  • Do Not own more than two shares in the same industry
  • Do Not plunge into the market. Spread the investments over time.
  • Use Stop-Sell orders to limit risk

Shares with consistent, predictable earnings growth are the safest shares you can buy. They represent the best managed companies in America. A share portfolio with an average earnings growth rate of at least 14%/yr. has a high probability of doubling in five years. In twenty years it will have increased by 1,500 percent.

If you bought 10 shares, and limited your loss on any single share to 10% by using Stop-Sell orders, your total portfolio risk is only 10%. Your risk on any single share is only 1% of your total portfolio. How many investments can you think of that have the upside potential of shares with such limited risk exposure?

MYTH #3: BUY STOCKS ON THE WAY DOWN AND SELL ON THE WAY UP.

There's an old adage that says the way to make money in the stock market is to buy low and to sell high. That, of course, is an irrefutable truth. The only problem is that many investors confuse this bit of conventional wisdom with the assumption that if the price of a share is going down it is low, and if it is going up it is high. Consequently, they buy shares on the way down and sell on the way up. There's hardly a worse thing an investor could do.

Shares are bought on the expectation that they will go up. If a share is going up in price, it is fulfilling that expectation. When the price is going down, it is denying that expectation. Therefore, it is logical to buy a share when its price is going up. Moreover, one of the best times to buy a share is when the price has broken above an old high. At this point there are no unhappy holders who are waiting to dump the share. If the share is fairly valued, there should be clear sailing ahead.

MYTH #4: STOCKS ARE A HEDGE AGAINST INFLATION

For many years stockbrokers and mutual fund salesmen have been saying that shares are a hedge against inflation. Well, they are and they aren't. It depends on how you look at it.

A true inflation hedge is one that goes up in value with higher inflation...like a house, or gold, or collectibles. But, the fact is, inflation is the stock market's number one enemy. When inflation goes up, interest rates go up and two things happen. For one thing, investors say, "Golly, I can make all that money on high interest rate bonds so why should I invest in stocks." So they take their money out of the stock market, and share prices go down. The second thing that happens is that the cost of doing business goes up. So corporate earnings go down, and share prices go down.

So why in the world would anybody say that shares are a hedge against inflation? It's because they can make money in shares faster than inflation will eat it up. All they have to do is invest in shares which have earnings growth rates higher than the sum of inflation and long-term interest rates. When they do that, the price of the share will go up faster than inflation. And they will be whipping inflation by staying ahead of it.

MYTH #5: YOUNG PEOPLE CAN AFFORD TO TAKE HIGH RISK

Of all the myths in the market, this may be the cruelest and the most foolish. Everyone knows that the elderly are not supposed to take risks. They must be very conservative because their earnings power is limited. They can't afford to lose their money! Well, who decided that young people could afford to lose their money?

If any group needed to watch every penny, it's the young. They need money to start a family, buy a house, buy furniture, save for the future and on and on. Furthermore, young people usually are at the low end of the earnings scale. They have precious little disposable income.

Young people have an invaluable asset on their side, however. Time. They don't need to take risk. They can invest in tried and true companies that make money year in and year out. At 10%/year growth, their investments will double every seven years. By the time baby is off to college, that initial safe investment has increased by a factor of eight.

When you have time, you can afford patience. Patience pays off in the market.