Understanding some common stock investing myths can make a significant difference in wealth over your lifetime. Here are five common myths you should be aware of.
Myth 1: Earnings are more important than the strength of a balance sheet.
It is a mistake not to adequately analyse a balance sheet, as earnings are easily manipulated and can be volatile. The balance sheet provides the foundation upon which any company must build. If it is weak even a profitable company can quickly go bust if earnings drop. Whereas, a financially strong company can obtain access to finance more easily and often makes an attractive takeover candidate if its earnings fall.
A balance sheet is a financial statement that summarises an organization's assets, liabilities, and shareholders' equity. It gives viewers a snapshot of what's owned and what's owed.
Myth 2: The key to value investing is getting stocks at low prices.
Don’t buy a stock based on its price alone. What you need to work out is the value of a stock, from which you can then decide if the price is cheap or not. For example, when Warren Buffett first bought Coca-Cola stock many thought it was expensive, yet the price he paid turned out to be cheap.
Seth Klarman in his book Margin of Safety, explains that the real success of an investment must not be confused with its success in the stock market. A rise in the stock price does not ensure that the underlying business is doing well or that the price increase is justified by a corresponding increase in underlying value. Likewise, a price fall does not necessarily reflect adverse business developments or value deterioration.
Hence his advice: Value in relation to price, not price alone, must determine your investment decisions.
Myth 3: Hot growth stocks outperform boring ones.
Maybe in the very short term. As Benjamin Graham wrote, in the short term, the market is a voting machine. Popularity rules the day. Don’t run for the most popular flavour of the day. In the long term, the market is a weighing machine, gravitating toward a company’s true intrinsic value. Buy on the cannons (when stocks are unpopular), sell on the trumpets (when euphoria reigns).
Just witness the outperformance of a stalwart like TCS over the past few years, while some go-go growth stocks like DLF went bust. Moreover, beaten down boring stocks can often shoot up on any good news, while glamorous growth stocks on high price-to-earnings ratios (P/E) may need only disappoint slightly to see their price plummet.
Myth 4: You need a complex strategy to beat the market.
The most simple strategy of buy cheap and sell dear, and building in a margin of safety by so doing, has been shown to outperform any other strategy. If a strategy is over-complicated it is best to avoid it.
The future is inherently uncertain, and one should always demand a margin of safety. The more uncertain a situation, the greater the margin of safety should be.
Fair value is what the stock is worth. Fair value estimates aren't meant to be automatic buy or sell indicators. To determine reasonable buy and sell prices, one has to look at a stock's margin of safety. It is wise to buy when a stock's fair value estimate is considerably more than its market price. This is important because buying when the stock is trading at a discount protects the investor just in case the fair value estimate is too optimistic. In other words, a margin of safety gives you some error cushion in case your estimate is too high.
On the other hand, when the market price has climbed far above the fair value estimate, this may be an indication that the stock is overvalued and potentially vulnerable to any hiccups that might come along.
So instead of buying shares based on what everyone else is doing, buy a stock only when it's selling at a decent margin of safety to your estimate of its fair value. Don't even think about the overall direction of the stock market, because that's impossible to predict with any consistency. Patience is indeed a virtue when using this approach, because often it may take many months, or longer, before a suitable opportunity presents itself.
Obviously, to determine whether a particular stock is trading with a sufficient margin of safety, you must have some sort of an estimate of what you think the stock is worth. Also, you must determine how much of a margin of safety you'll require before buying a stock. If the firm is not very risky, you could be content with a 15-20% discount to its fair value. If the firm is riskier than average, you may demand a 30-40% discount. Ultimately, it's your decision and varies depending on the company in question.
Myth 5: This time it’s different.
As long as stock markets exist, so will bubbles. And it will not be different. Asset bubbles have reoccurred continually throughout history yet while they are taking place you’ll often hear how the fundamental rules and principles of investing have somehow changed this time round. It isn’t so. Had investors ignored arguments to justify stretched valuations for companies that weren’t even profitable during the dotcom boom (1995-2000), much money would have been saved.
Believing that what they are investing in and the period they are investing in is out of the ordinary, investors fool themselves into losing money. That is why Sir John Templeton said that the four most dangerous words in investing are: “This time it’s different”.
