Truth and myths of the stock market
Trading on the stock markets for the average person looks like something supernatural and fantastic.
Myth #1: The price-to-earnings ratio shows whether a stock is cheap or expensive
The price-to-earnings ratio is easy to find. Virtually any financial publication, at least in the West, publishes price-to-earnings ratios. It seems that everyone talks about this ratio when discussing stocks. It turns out that this ratio is an excellent indicator in choosing a stock.
Right?
Wrong!
If you were told that Pyramid Corporation's price-to-earnings ratio was 7 and Bubble Company's was 14, would you buy Pyramid Corporation instead of Bubble Company? Maybe so, but you wouldn't feel comfortable making such a decision. Why not? Because you need more information. Before deciding to buy stock in any company, any self-respecting investor will gather maximum information to make the right decision. One of the most important things you would want to know is the value of each company's stock based on its earnings, profitability and other key financial data. In other words, you would want to understand what the actual value of those stocks is. The price-to-earnings ratios did not reflect the value of the stock in any way!
What an investor really needs is real-value to price ratio. Knowing the ratio of real value to price, investors would immediately be able to determine whether the stock price is low, high, or real. But that means we need to calculate the value in some way. Of course, there are theories and formulas for calculating real value. But they are complicated, and some experienced investors even say they are incomprehensible. Consequently, most investorseven professionals, do not start with the actual value of the stock! They resort to such trivial means as comparing price-to-earnings ratios.
Myth #2: To make good money in the stock market, you must assume a high degree of risk
A woman recently told me, "I'm just scared to death of stocks. I can't afford to lose my hard-earned money. That's not to say that understanding the high degree of risk in investing in securities doesn't have some merit. Many investors have lost significant amounts of money in the market. The spectacle of investors throwing themselves out of windows in 1929 is an eloquent reminder of the risk inherent in investing in securities.
The crashes of '29 and '87, the failures of stock-trading software, the sale of stocks by persons and institutions with insider (confidential) information, leveraged acquisitions, etc. have also contributed to the image of securities investing that usually accompanies casinos. To a large extent the investment community is its own worst enemy in discouraging private investors. And that's too bad, because investing in securities is one of the best ways for the average person to make a significant fortune, and it doesn't really have to be a very risky business. All it takes is a few simple techniques and some discipline. In fact, it can be much safer than investing in real estate, collectibles, or your own business ventures.
How to make good money on stocks with minimal risk?
- Buy stocks with a consistent, predictable rate of income growth: buy stocks whose rate of income growth equals at least the sum of the current inflation rate and interest rates.
- Invest in a variety of stocks: don't invest more than 10% of your money in a single company's stock; don't buy more than two stocks in the same industry.
- Do not rush headlong into the market. Allocate your investments over time.
- Use stop orders to the sale in order to minimize the risk.
- Stocks with consistent, predictable earnings growth rates are the safest stocks you can buy. They tend to represent America's best companies.
- A portfolio of stocks with an average earnings growth rate of at least 14% per year has a high probability of doubling in five years. In twenty years it would increase by 1.500%.
- If you bought shares of ten companies and limit your losses on the shares of each company to 10% using stop orders to sell, your total risk on your portfolio is only 10%. Your risk on each specific company's stock is only 1% of your total portfolio. How many types of investments can you name that have the potential to grow stocks with this limited exposure?
Myth #3: You should buy a stock when its price goes down and sell it when it goes up
There is a widespread belief that if you buy securities when they are cheapest and sell them when they are most expensive, you will surely make a profit. This truth is irrefutable. However, many investors think that if stocks go down in value, they are cheap, and if they go up in value, they are expensive. So they buy stocks when their price goes down and sell when it goes up. This is a big mistake.
Shares are bought in the expectation that they will begin to rise in value. If the price of a stock goes down, it means that a miscalculation has been made. That is, in principle, it is logical to buy those shares whose price is going up. Moreover, it is best to buy stocks when their price exceeds the previous top mark. Then there will be no disgruntled stockholders ready to dump their shares on the market at any moment on the cheap. If the shares are really valued, they should have brilliant prospects ahead of them.
Myth #4: Stocks are insurance against inflation
For many years stockbrokers thought of stocks as insurance against inflation. You can agree or disagree with that. It all depends on one's point of view.
The real hedge against inflation is what goes up in price at the same time inflation goes up. real estate, jewelry, collectibles, etc.. As far as the securities market is concerned, inflation is a real threat to it. As inflation rises, interest rates rise, which has a number of negative consequences. On the one hand, investors, giving preference to bonds with high interest rates, deprive the securities market of capital injections. On the other hand, the cost of doing business may skyrocket, companies' profits will begin to fall, and stock prices will rise.
That is why it is at least wrong to claim that stocks serve as a hedge against inflation. One can earn on stocks faster than inflation eats away at the money invested. To do this you need to invest in stocks with a sufficiently high growth rate of return on them. Then the price of the stock will rise faster than inflation. It's as if you are spurring inflation by moving ahead of it.
Myth #5: You can afford a high degree of risk
In all likelihood, it is the cruelest and stupidest myth of all stock market myths. Everyone knows that older people don't like to take risks. They have to be very careful because the value of future profits is very limited. They, you see, cannot afford to lose their money. But the same is true for young people.
Young people, for the most part, have to count every penny. Starting a family, buying a house, accumulating capital, etc., require constant spending. It is young people, with the possible exception of the career-obsessed yuppies, who are at the bottom of the income scale. Their net income is very low. There is no way they can afford to take risks.
In addition, young people have one important advantage: time. What's the point of taking a risk when you can invest in proven and reliable companies that bring profits year after year? At 10% a year, their investment will double every seven years. By the time it's time for the growing offspring to go to school, that initial, reliable investment will have increased eightfold.
When you have time, you can afford to be patient. Patience in the marketplace pays a hundredfold.