FOOL'S EYE VIEW
Four Stock Market Myths - Debunked

By David Kuo (TMFDragon)
February 7, 2002

Carburton Street, London -- Stock trading (or the rudiments of it) have been around since the 1700s. And over those 300 years, investors have perpetuated a collection of unfounded and false notions about the stock market. Sadly, some of these myths have become so entrenched that we sometimes forget they are merely half-truths or untruths which bear little resemblance to reality.

Myth 1: The Stock Market Is A Casino For The Rich

If you look carefully, there are in fact two separate myths hidden in this seemingly simple assertion: the stock market is a place where gambling takes place and the stock market is only for the well-heeled. Neither of these assumptions could be further from the truth. But let's put to rest the first idea that the stock market could be in any way construed as a den of inequity.

A stock market is a place where people can buy a stake in a company through the purchase of common shares. That stake in the company entitles the shareholder to a portion of the profits and it also enables the shareholder to benefit from the company's growth as the business flourishes. Of course, if the business fails to do as well as expected, shareholders will have to bear some of the brunt. But if the business is well run, its value should increase over time and benefit all the shareholders proportionately. Everyone's a winner.

Gambling, on the other hand, is a situation where the winners take from the losers. And more importantly, it is the bookie (or "house") that generally wins because the middleman, as ever, always gets his cut. In gambling, there is no wealth creation and over the long-term, the more you gamble the more you stand to lose. It is known in the trade as a zero-sum game. This is very different to investing, where wealth is created and everyone stands to prosper.

Let's turn now to the assertion that the stock market is just for the rich. Again, nothing could be further from the truth. Did you know you could start investing in the stock market from as little as £25 a month? Sounds implausible, but it's true. For example, low-cost index-tracking ISAs offer investors a simple way of direct exposure to the stock market. So while it's just not true that the stock market is the preserve of the rich, you could certainly increase your wealth by participating as an investor.   

Myth 2: Timing Your Investment Is Important

Traders like to think that they can accurately predict stock market movements. It is an unfortunate flaw of human nature believing it is possible to forecast what the future has in store. This notwithstanding, so-called market experts will often try and convince gullible investors, at great lengths, that they have at last cracked the problem of predicting what tomorrow will bring -- only to find that they are right 50% of the time! But what is undeniable is that the overriding emphasis for businesseses is to grow. And it is for that reason alone that the long-term movement of the stock market will be upwards.

Myth 3: Cheap Stocks Are Better Value For Money

Cheap stocks are cheap for a reason -- nobody wants them at a higher price. One of the most commonly used yardsticks for valuing stocks is the price to earnings (P/E) ratio. It is a readily available indication of how much you will need to pay for every pound of profit that the company makes. By this measure, a company that is valued on a P/E of 20 is twice as expensive as another that only has a P/E of 10. What can be more confusing is that these two different companies might even compete within the same sector. So which business is likely to be better value for money? Sadly, valuing businesses solely using the P/E ignores the growth prospects of companies and it also assumes that all businesses have the potential to grow their earnings at the same rate. Unfortunately, this is as far removed from reality as the two earlier myths on gambling and market timing.       

Myth 4: Newton's Law Of Gravity Applies To Stocks And Shares

When that apple fell on Sir Isaac Newton's head, it prompted the great physicist to propose Newton's Third Law. But while the Law of Universal Gravitation explains adequately why masses fall with the same acceleration on the surface of the Earth, it has little place in the world of investing. The "What Goes Up Must Come Down" myth is one that can often incorrectly cause investors to sell their shares and 'lock in profits', only to find that the stock carries on rising rapidly. However, it is just as likely that the shares could well adhere to the Laws of Gravity and come down with a bump. But investors should remember that again, it is the performance of the company that is the over-riding principal that determines the future movement of the share price, not some sort of gravitational pull.

We will never be able to rid the market of myths because they are designed to offer a plausible explantion for events that are intrinsically inexplicable. Investors should remember that the stock market is a good investment vehicle. Most of us, through our exposure to pension funds, are already investing directly in the market.