Myth: Growth Beats Value
Strong revenue and earnings growth attract attention. This is particularly the case for companies operating in emerging industries or selling innovative products and services. Such growth makes for great news stories and everybody likes a winner. Therefore, it only stands to reason that soaring growth should lead to soaring stock prices.
The reality is different. Long-term data published in the 2013 Ibbotson SBBI Classic Yearbook (a compendium of historical data on stock and bond performance) shows that value beats growth. Over the period from 1928 through 2012, a portfolio invested in large-cap growth stocks realized an annualized return of 8.8%. Over the same period, a portfolio invested in large-cap value stocks realized an annualized return of 11.0%.
Myth: Good Companies Always Make For Good Stocks
Logic would seem to dictate that good companies should make for good investments, but the two can be very different. A company can have a charismatic CEO and a great product, but little to no profitability and a business model that consumes, rather than generates, cash. A company can also be very successful and have a stock with a high valuation because of its success.
Myth: Large-Cap Stocks Are The Only Option
The investment media focuses on stocks belonging to the Dow Jones industrial average or the S&P 500 index. This makes sense since these are the most widely held and familiar companies. Yet the entire S&P 500 accounts for just 10% of all U.S. exchange-listed stocks.
Since 1926, small-cap stocks have outperformed large-cap stocks with an annualized return of 11.9% versus 9.8%, respectively, according to the 2013 Ibbotson SBBI Classic Yearbook. Smaller companies tend to be overlooked more, and therefore their stocks have a greater chance of being underpriced. Just understand that smaller-cap stocks are subject to more price volatility and will have lower levels of trading volume, so there is a trade-off for the higher level of returns.
Myth: It’s Easier For A Low-Priced Stock To Double In Value
It only takes a $2 increase for a stock trading at $2 per share to double in price. A $20 increase is required for a stock trading at $20 to double in price, however. So, it’s easier to make money with the $2 stock, right?
Answering “yes” ignores a very basic investing concept: In order for a stock price to double in value, the company’s entire market capitalization also has to double in value (assuming no change in the number of shares outstanding). This is because market capitalization—the value of the entire company—is determined by multiplying the number of shares outstanding by the current share price. This simple formula explains why it doesn’t matter if a stock trades for $2 or $20, investors have to believe the entire company is worth twice as much as its current value in order for a stock’s price to double.
Myth: Paper Losses Don’t Matter
When a stock’s price falls below its purchase price, some investors rationalize to themselves that they haven’t lost anything because they haven’t sold the stock. This line of thinking is wrong because stocks are liquid assets, meaning they can be sold (liquidated) quickly, and are “marked-to-market” throughout the trading day. Therefore, a stock is only worth what it is currently trading at.
This does not mean you should be quick to sell a stock whenever its price drops. The market ebbs and flows, and you will have losses. Even the most successful investors incur several losses over their lifetimes. What it does mean is that you should never hold onto a stock for the primary purpose of trying to get back to breakeven. Re-examine the company’s prospects and the reason you bought the investment in the first place. If you didn’t own the stock currently, would you buy it now over another stock that also meets your investment criteria? The answer may help guide your decisions.
Myth: Buy What’s In The News
Every morning, the media and investment Web sites discuss the stocks making headlines. Typically, these are stocks moving in reaction to an event, such as an earnings release, a new product announcement or an analyst upgrade. The reports make it sound like many people either own or are buying the stock.
But by the time you hear the news, it has already been disseminated. Professional trading organizations react to the news immediately and will price in any changes in the stock faster than you can log into your brokerage account, much less place a trade. This is why trying to react to the day’s headlines is a losing game. You simply cannot beat professional traders at their own game.
What you can do is go around them. If a stock is making headlines with good news, take your time to analyze the stock and look for a good entry price. Then plan on holding onto the stock for an extended period, eyeing the valuation, the business, the financial statements and other pertinent factors. Unlike a professional, you don’t have to report your performance to anyone, so you can patiently invest and hold onto your stocks.
There is also another reason not to be reactive to the headlines. Research by Yale professor Roger Ibbotson shows that stocks with less relative trading volume tend to perform better. The reason is simple: Since there is less focus on them, these stocks are more likely to be mispriced and therefore undervalued. So, consider looking at the stocks that aren’t making the headlines for potential investment ideas.
Myth: Dividend Stocks Have Lower Returns
Dividend stocks are often perceived as stable, slower growth companies. As such, growth investors may view them as boring and not capable of delivering high returns.
Yet the reality is far different. Research from Ned Davis Research finds that dividend-paying stocks deliver higher total returns than non-dividend payers. During the period of January 31, 1972, through January 31, 2013, stocks of companies that either initiated or increased their dividends realized annualized returns of 9.7%. During the same period, stocks of companies that didn’t pay dividends returned 1.8%. On an initial $1,000 investment, this difference equates to a $42,000 increase in wealth for buying dividend-paying stocks.
Myth: Beating The S&P 500 Is Easy
A great deal of marketing dollars is spent promoting concepts designed to convince investors they can beat the market. The data suggests otherwise. Out of the 258 large-cap mutual funds with 10-year return histories covered in AAII’s Guide to the Top Mutual Funds (AAII Journal, February 2013), 56% failed to beat the return on the S&P 500. These are funds run by professionals who graduated from topnotch business schools with teams of analysts and access to research, economists and corporate executives.