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Wednesday, August 13, 2014

5 enduring stock market myths debunked

The quote: “A lie repeated often enough becomes the truth” has been variously attributed to Vladimir Lenin and Joseph Goebbels. Adolf Hitler wrote in Mein Kampf: “The greater the lie, the greater the chances that it will be believed.”

Is a myth the same as a lie? Not quite. A lie is a deliberate attempt to suppress or conceal truth. Oxford Dictionary has this definition of myth: ‘A widely held but false belief or idea.’  So, a myth probably evolves from a lie.

Why do stock market myths exist, and why is it necessary to debunk them? One of the ploys used by analysts and fund managers is to propagate myths so that less-educated investors (in terms of stock market knowledge) remain confused.

Some times, analysts and fund managers hide behind these myths because they are confused about the price movements in the market and don’t want to look like fools if they predict something and the opposite happens.

It is the small investor who starts believing these myths and gets taken for a ride in the process. So, it is important to understand the difference between what is a myth and what is truth.

Here are some enduring and oft-repeated stock market myths, and the truth behind those myths:

1. The stock market is a ‘zero sum’ game because for every buyer there is a seller

Wikipedia defines a ‘zero sum’ game thus: ‘In game theory and economic theory, a zero-sum game is a mathematical representation of a situation in which a participant's gain of utility is exactly balanced by the losses of the utility of the other participant(s).’

The myth is not the ‘zero sum’ part, but the ‘for every buyer there is a seller’ part. Any one who has bought or sold a large lot knows that. If you try to sell 1000 M&M or L&T shares in the market, it is unlikely that some buyer is just waiting to buy those 1000 shares from you. Chances are, there are several buyers each wanting to buy 50 or 100 shares each.

If the stock price falls after you complete your selling, then you ‘win’ and the several buyers ‘lose’. If after a few days, the stock price starts to rise and goes above your selling price, then you ‘lose’ and the several buyers who bought from you ‘win’.

2. There is plenty of cash waiting in the sidelines

The myth is to justify why Nifty should move higher. The truth is: cash waiting on the sidelines will always remain on the sidelines in the secondary market. Why? Imagine you have just received a fat bonus due to excellent performance at work, or have made a big profit after selling some real estate. You now wish to enter the stock market to buy some shares, but are hesitant because of high prices.

So, you have cash waiting on the sidelines, right? Now, a correction sets in and you find some attractive buys to deploy your cash. What happens to the cash that you had on the sidelines? It just changes hands and goes to sellers of the stocks. Now you know why a stock market is actually called a stock exchange.

You exchange your cash for stocks. The seller(s) exchange their stocks for cash. The cash goes back to the sidelines – minus some STT and brokerage. (In the primary market, cash does go from the sidelines into a company conducting an IPO. That cash will be used for purchasing productive assets and hopefully won’t get stolen.)

3. Time in the market is better than timing the market

Say that to a Japanese investor (the Nikkei has gone nowhere for many years) and he will probably call you a ‘bakayaro’ or even a ‘chikuso’! This myth works great for fund managers, because the longer investors stay invested in a fund the better it is for the fund manager. He has more funds to invest and can make some long-term bets.

But if you want to generate market beating returns, you have to resort to ‘timing’ your entries and exits. That doesn’t mean frequent churning of individual portfolios. But exiting if the Nifty P/E moves above 22 or buying when Nifty P/E falls below 14 can significantly improve your returns.

4. This is a ‘hope’ rally, or a ‘liquidity-driven’ rally

This is what analysts say when they have advised investors to book profits at every rise, and Nifty keeps moving higher and higher. I mean, talk about stating the obvious! Has there ever been a rally without hope or liquidity? Investors buy because they have the money to invest and hope that the index will move up.

When liquidity gets sucked out of the market – whether due to profit-booking or bunching together of IPOs (though that hasn’t happened for some time) - what happens to the rally? It stalls. You don’t need a degree in Nuclear Physics to understand that.

5. This is a stock picker’s market

Except for the period between Oct and Dec 2007, when even cats and dogs turned into lions and tigers overnight, I can’t recall a time when it wasn’t a stock picker’s market. If you wish to build wealth for the long-term (as opposed to enjoying the adrenaline rush in day trading), you have to learn how to pick stocks that can and will stand the test of time.

How will you know that beforehand? The best way is to choose stocks that have already withstood the test of time – like HUL, Colgate, ITC, M&M, Tata Motors. Does that mean you should stay away from mid-cap and small-cap stocks? Yes, and no.

Yes, if you are not confident about the process of stock picking. No, if you follow these simple and well-documented steps. However, following those steps will require discipline and diligence. The eventual rewards will be much more than adequate.

4 comments:

Prasad Nalam said...

Very good piece. These myths often results in small investors either losing money or not getting into th market at the right time.

Subhankar said...

Thanks for your comments, Prasad.

Most small investors lose money because they don't follow a stock picking process that is suited to their financial goals and risk tolerance.

AYMANAM said...

Well said sir, but what about fear and greed

Subhankar said...

Fear and greed will always cloud human judgement. That is why it is important to have a plan and a process.

Once you have a financial plan and an asset allocation plan in place, and assess your risk tolerance, much of the uncertainty that causes fear and greed is removed.

You just need to follow the process of regular investments of your savings, and periodic reallocation of your portfolio.

It is a boring but effective way to build wealth for the long-term.