Stock Market Myths

Author: Mahesh Mohan

10 Apr

Every person who invests in the market has his individual experiences to share; nevertheless there are few common misconceptions. To become a successful market player one must be well aware of the truth behind these. For instance, very often we hear people saying that the elderly are not supposed to take risks. They must be very conservative because their earnings power is limited. Well, who decided that young people could afford to lose their money? Taking another example, it is easy to say that stocks that go up must come down but laws of physics do not apply in the stock market. There is no gravitational force that pulls stocks back to even. To give you a better understanding, let us go through the widely prevalent myths in the market that one must be beware of.

Myth 1: The market is always right

Most people believe the market is all-knowing and that the current price of a stock reflects all material information about the company, its history and its prospects. This does not hold true always. Often you would have noticed a stock double or triple in the space of a month but this sharp rise is not preceded by any new information about the company. It’s very rare for a company’s fundamentals to change so significantly over a short span of time. So, what’s changing is simply the market’s perception about the stock. Understanding what the market is trying to say is different but to conclude that it’s invincible would be a big mistake. The market will paint a new picture every day so it will be far more useful to consider the market as extremely prone to swinging to extremes, rather than as an all-knowing and all-powerful force that many market watchers assume it to be. For only then can you use the market to your benefit, and buy low and sell high, rather than become its slave and let it affect not only your wealth but also your health.

Myth 2: Price is not an issue while investing in good companies

A large number of investors propound that one cannot go wrong if you buy into good companies, no matter what their share prices are. This philosophy is often ascribed to Warren Buffett, and his so-called followers swear by it. The truth is that, though Buffett believes in buying the best businesses, he acknowledges that if your entry price is unrealistically high, you might have to wait an eternity before you make decent returns from the stock. Usually, in such cases, your patience runs out on you, and you exit at an inappropriate time.

Let us take the example of Wipro, which rose to almost Rs 10,000 in February 2000. This translated into a P/E (price-earnings) ratio of almost 800 on its earnings for the year ended March 2000. Yet, investors continued to buy Wipro as if the sky was the limit. Wipro is a fantastic company, no doubt, but sometimes speculators are able to generate a frenzy that leaves rationality in the dumps, and along with it, the fate of many investors. Those who purchased Wipro at that five-figure price are mostly unlikely to see those levels again. So, the price at which you buy a stock is important.Buffett, in fact, advises investors to answer two questions while searching for investment picks: which company and at what price.

Myth 3: When a stock hits its 52-week low, it’s time to buy

Bottom fishing is a popular investor pastime, but it’s usually the fisherman who get the fish. The 52-week high/low is one of the most widely used parameters by many investors to buy or sell a stock. The logic: all stocks have a 52-week low and 52-week high, and that range is usually at least 100 per cent. So, if you can buy a stock near its low and sell it near its high, you should be able to earn good returns but grabbing a rapidly falling stock results in a lot of surprises, because inevitably you grab it in the wrong place. For instance, attempting this strategy with technology stocks would call for a lot of courage to face up to the consequences. Most technology investors tend to follow ‘momentum investing’ (buy a stock when it starts to gain momentum and sell it when it begins to lose steam). When momentum takes a stock to a new low, there’s no telling where it will eventually end up. Moreover, a rebound does not always take place. On the contrary, the stock might just keep sinking to new lows, till it reaches a point where nobody wants to buy it at all. So, if you are interested in buying a stock, it ought to be for a more sensible reason. An investor needs to research his stocks very well. Zeroing in on the blue chips is not easy, as there are only a handful of companies that follow such a trend. So, before you jump to any conclusions, think really hard.

Myth 4: Rupee cost averaging is always a good defensive stock strategy

Rupee cost averaging advocates buying more of a stock if its price falls in order to average out the purchase price. Say, you bought 100 shares of a company at Rs 100 (total consideration: Rs 10,000), after which it falls to Rs 50. At this price, you should buy 200 more shares (total amount invested remains Rs 10,000) so as to bring down your purchase price.

Sure, you bring down your purchase price, but is it worth it? If you buy something whose intrinsic value is only Rs 10, first at Rs 100 and then at Rs 50, no matter how much you average down, you will still be buying onions at the price of orchids, and sooner or later, either your money will run out or you may be the only investor left in the company!

So, the more important thing to look at is the true worth of your investment. Once you have figured that out, it is much easier to apply theories like rupee cost averaging or buying a stock when it hits its 52-week low.

Myth 5: Penny stocks are great buys, as they have little downside

Is a stock priced at Rs 10 cheaper than another priced at Rs 1,000? Well, some people will tell you it is. Their reasoning: how much lower can the stock priced at Rs 10 go? Chances of price going to zero are more in favour of a penny stock rather than in case of Wipro or Infosys. However, some people may say that all the upside is already factored in the Rs 1,000 stock. The story is already recognised and there is no more to be gained from buying this stock.

But, the truth is that the absolute price of a stock has absolutely nothing to do with its future prospects, and hence, its valuation. A stock issued at Rs 10 (maybe 10 years ago) and now quoting at Rs 1,000 suggests that the company has done well over these last 10 years in terms of earnings and profitability while on the other hand, stocks trading at or below par suggest something drastically wrong with the company and/or its management.

Don’t take any company for granted – whether it is Infosys or just a penny stock. Put their annual reports under the lens every year before taking any investment decision. The price of a stock must be viewed in relation to its earnings, its book value, the dividend per share and revenues per share, rather than on an absolute basis. More importantly, you must also analyze qualitative factors relating to the company’s business, its longevity, profitability and sustainability of those profits.

Myth 6: Fallen angels will all go back up, eventually

Frequently people say that a particular stock has gone down 20 percent or more, so it should not go lower. Shareholders of TV18 would have a good experience of this. The share got listed at Rs 1,450 in the boom of 2000 and with the bear market it went on making new lows and each time the stock continued its southward journey until it reached the price of Rs 36. Taking another hypothetical example suppose you are looking at two stocks:

XYZ made an all-time high last year around Rs 50 but has since fallen to Rs 10 per share.
ABC is a smaller company but has recently gone from Rs 5 to Rs 10 per share.

Which stock would you buy? Believe it or not, all things being equal, a majority of investors choose the stock that has fallen from Rs 50 because they believe that it will eventually make it back up to those levels again. Thinking this way is a cardinal sin in investing! Price is only one part of the investing equation. The goal is to buy good companies at a reasonable price. Buying companies solely because their market price has fallen will get you nowhere. Make sure you don’t confuse this practice with value investing, which is buying high-quality companies that are undervalued by the market.

Myth 7: P/E ratio tells you whether stocks are cheap or expensive

P/E ratios are easy to find. Every newspaper, magazine and stock report publishes P/E ratios. Everybody seems to talk about them when discussing stocks. So, P/E ratios must be a great way to compare stocks.

As an investor if you were told that ABC Ltd had a P/E of 7, and XYZ Ltd had a P/E of 14, would you buy ABC Ltd instead of XYZ Ltd? You might, but you wouldn’t be comfortable making that decision because one needs more information. You’d like to know a whole lot of things before you decide which stock to buy. One of the most important things you’d like to know is the worth of each stock based upon its earnings, profitability and other key financial data. In other words, you would like to have a sense of the stock’s intrinsic value. P/E ratios don’t say anything about a stock’s value!

What investors need is a ‘value-to-price’ ratio. With this ratio, investors would know immediately whether a stock was cheap, expensive or fairly priced. But this means we have to have a way of computing value. Of course, there are theories and formulas for computing intrinsic value. But they are complex, and some sophisticated investors even say they are unfathomable. Consequently, most investors don’t look at stock’s intrinsic value. They resort to trivial devices like comparing P/E ratios.

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