Everyone is looking for an easy way to make money. The stock market has delivered some impressive returns over the years. Many people make money and many lose money. Let us look at some myths and realities about investing that clients should understand.
1. Myth: The stock market always goes up. If you look at the Ibbotson mountain chart, the U.S. stock market has risen for decades, over 10% a year on average since 1925. There is no risk.
Reality: Stocks sell at a multiple of earnings, the price/earnings ratio. Assuming the PE stays constant, when earnings increase, stock prices increase. Rising prices year over year requires continuous growth in earnings. If earnings decline, stock prices go down. Two consecutive quarters of GDP declines is considered a recession.
2. Myth: Companies do not need to have earnings. A good idea is all you need. This ties into the New Economy thinking of the late 1990s, but we see it again today. The concept ties in the “If you built it, they will come” concept. Either the world will beat a path to your door or a big company will buy out the little company that has that great idea.
Reality: Investors want their money back plus a healthy profit. The dot-com bubble burst in March 2000 when the markets decided earnings did matter after all. Stocks are valued on PE multiples.
3. Myth: Money put into savings in a bank is guaranteed. This logic is based on the concept of FDIC deposit insurance, which protects you up to $250,000 per depositor. This is true for U.S. banks covered by FDIC insurance.
Reality: Not all banks are in the U.S. There are banks all around the world. Some have great names and impressive buildings, but are operating overseas, not in the U.S. They might be in the Caribbean. They might offer interest rates that seem too good to be true, but if they aren’t in the U.S., they are not guaranteed by the FDIC.
4. Myth: The smartest way to invest is by using OPM or other people’s money. This is the logic behind investment vehicles like hedge funds, which use a 2+20 formula. They get 2% in fees to run the fund and 20% of profits over a certain threshold.
Reality: Because the average investor cannot setup their own hedge fund, the next best thing might be buying on margin. You put up your own money, borrow more money from a brokerage firm and buy stock. If the stock goes up, you sell, repay the loan plus interest and keep the rest for yourself. The OPM dream becomes a nightmare when stocks go down. All the losses are felt on your side of the ledger. The loan never goes down until you repay it.
5. Myth: Dividends are a little bonus that do not need to be reinvested. You buy stock. You see the price change every day. Some shares pay out cash quarterly. The amounts are often so small, they look like they hardly matter.
Reality: Reinvesting dividends delivers the compounding effect when considering total return. According to CNBC, since 1945, dividend reinvestment contributed 33% of the overall return of the S&P 500 index.
6. Myth: You can’t lose money if you buy a product sold by a bank. This might have been true decades ago when banks took in deposits, made loans and that was it. Later, banks started selling investment securities like mutual funds and bonds to the general public through financial advisors.
Reality: Decades ago, some people might have assumed everything you bought through a bank was guaranteed by the FDIC. They are careful today to differentiate between savings vehicles and investments, often sold by two separate organizations.
7. Myth: If I don’t start saving early, I can always catch up. This works on the logic retirement is so far in the future, twentysomething investors can put that pot on the back burner.
Reality: There’s an expression, “It’s not about timing the market, it is time in the market.” The government might let people who delayed saving for retirement to make catch up contributions, but the extra amount they can put away is far less than the amount they would have saved if they contributed on a regular basis.