5 common misconceptions about the stock market

There are some common misconceptions about the stock market which inexperienced investor may believe is true. Here are five common myths and the reasons why these may not true.

1. The stock market is like the economy

A common misconception people have is that the stock market should behave exactly the way the economy does. When the economy is performing poorly, people think the stock market should do the same. However, the stock market is not the economy. Share markets are forward looking. Stock prices usually factor in what investors think will happen in the future. Hence share markets usually rise during a recession as investors are looking into the future and believe there will be a recovery in the economy. Another reason the stock market does not reflect the economy is that that stock prices do not always reflect the intrinsic value of a stock. Investors may be willing to pay top dollar for stocks in a company that hasn’t been making money yet as they believe this company will be very profitable in the future. For more reasons detailing why the stock market is not like the economy, read our article “Why is the stock market rallying when the economy is heading into recession?”

2. You can make a lot of money day trading

Statistics do not support the success of day trading as 4 out of 5 people lose money (Business Insider Australia, 30 March 2010). One of the main reasons is that many day traders make emotional decisions. Day traders give up their job to trade full time to try and generate enough income to replace their salary. However as there is so much pressure to make money, they tend to make emotional decisions such as refusing to sell a losing trade and holding onto losses for too long. The high transaction costs involved in frequent buying and selling can also potentially erode the profits made. There are many successful day traders out there, but that success has often come on the back of years of experience and plenty of losses along the way.

3. Investing in the stock market is like gambling

Investing in the stock market is not like gambling. One of the main differences is that most forms of gambling can see you lose your money straight away as there is often a binary outcome. If an investor has selected a stock which is not performing, then it is highly unlikely they will lose their entire investment in one day. The same cannot be said about gambling where one bad bet means the player loses their entire cash outlay. There is also a level of risk control which an investor can exert when making decisions on what stocks to purchase. That is, if an investor is conservative then they can invest in companies that have stable and reliable earnings. A gambler has no control over the risk levels of their decisions as they are risking all their money each time they are making a bet. We outline more reasons on the blog on link “Why investing is not like gambling”.

4. Income investors should invest in high yielding stocks

There is a misconception that investors looking for income should buy stocks that pay a good dividend yield. However, after looking closely at income stocks and comparing the returns to growth stocks we can see that the income/dividend stocks do not outperform growth stocks when combining income and capital returns together. Growth stocks do not generally pay dividends when starting out as those companies usually like to reinvestment funds back into the firm to expand. However, what we have seen is over the years, these growth stocks do eventually increase their dividends so the investor benefits from capital appreciation and also an increase in yearly dividends paid. Income stocks on the other hand have kept payment of dividends consistent or have a lower dividend payout, but investors may have also experience capital depreciation. On a total return basis, growth investors have been better off with increasing dividends and increasing capital return. We recently compare the total return between Aristocrat (ASX:ALL) which is a growth stock and compared it with Telstra (ASX:TLS) which is an income stock in the article “Income investors should invest in growth stocks, not income stocks”.

5. Buying falling stocks is always a good idea

There is a misconception in the market that buying a falling stock is a good idea as the stock will be good value for money. The problem with this myth is you could be catching a falling knife, meaning a falling stock may fall even further. Many investors are scared of buying stocks that make new highs as they are in fear that it cannot go up forever. The whole point of investing is to have your stocks appreciate in value. This means that they have to be making new highs, otherwise what is the point? A company that is making new highs tends to continue making new highs, because it is often a good business. A company whose share price is falling for a long period of time is often a bad company which means it is a bad investment. It is a fallacy that declining share prices always mean revert and head back up again. This is because a company that has decreasing earnings deserves to have a decreasing share price. Conversely, a company with increasing earnings over time is justified in seeing its share price increase over time. The skill of course is in identifying which companies deserve to be heading higher and which ones don’t.

Lauren Hua is a private client adviser at Fairmont Equities.

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