Investing based on stock market myths can poison a portfolio. Whether it be half-truths, misapplication of important principles, or outright falsehoods, these myths can keep you from building a winning strategy and realizing the full potential of your investments. Working around the following three fallacies will help you make smart decisions at every step of a long-term investment plan.
1. Investing is like gambling
Gambling is a zero-sum game. You wager against another person or the house, and wealth changes hands based on the outcome of your bets. The stock market might appear to function the same way, but investing is different in important ways.
Stocks represent fractional ownership of large companies, and shareholders are ultimately entitled to the returns produced by the underlying company. If you owned a small business along with a few family members or friends, it would be weird to think of it as gambling, even if there are significant risks involved. The stock market is no different in theory for long-term investors, even if the process of trading and the way it's covered in the media might obscure this fact.
Businesses have an intrinsic value that is based on the future cash flows they will provide to shareholders, which are measured by dividends and corporate profits. All sorts of factors can influence stock performance in the short term, but a company's value should be dictated by fundamental financial performance in the long term. Understanding what drives long-term stock valuation can remove a lot of mystery from the market. Once you recognize that fundamental investing isn't gambling, you'll be on the way to making smart allocation decisions for growth.
2. Stocks only go up
This sort of thinking is becoming way too popular following a decade-long bull market. Even the sharp market downturn in 2020 was followed by a booming recovery that pushed indexes to all-time highs within months. Unfortunately, investments can fall in value, too -- investors in Blockbuster and Enron can attest to this. If you're picking stocks, you always run the risk of individual companies failing or rapidly losing value in the market.
Index fund investors will correctly point out that the major indexes have only risen over the long term. The S&P 500 has never posted negative returns over any 15-year window, and it has almost always grown over any decade-long span. Still, the whole market can move downward over shorter periods. Plenty of people took huge losses in major crashes such as the dot-com bubble and the 2008 financial crisis. The market has recovered and continued to rise each time, but it's a bumpy ride that left many fearful investors behind.
Volatility isn't necessarily a bad thing, though. Volatility is one of the forces that drives prices higher during short-term rallies. Even bear markets can be rare opportunities for long-term investors to acquire great stocks at heavily discounted prices before the subsequent recovery drives returns through the roof. Attempting to precisely time markets with massive sell-offs and repurchases is a bad idea that rarely results in long-term success. That said, you can shrewdly make modest adjustments to your portfolio allocation based on market conditions, such as economic outlook and valuation levels.
Accept that stocks can go up or down, then put yourself in a position to survive and advance when things get tough or thrive when the market is booming.
3. Returns are the only thing that matters
Investment performance will ultimately be judged on net returns, but process should be considered along with results when developing a strategy. You must evaluate risk when constructing a portfolio, and the best strategies balance risk with expected return. For diversified stock portfolios, volatility is the most prominent risk you'll face.
To see this in action, consider a portfolio of highly volatile stocks that you expect to outperform the market over a 10-year span. Over that time frame, that portfolio grows quicker than the S&P 500, but it also drops more steeply during bad spells. That allocation would look genius during bull markets, and that's at least partially due to timing. Following a market correction, a simple index fund might appear to have been a much wiser choice.
The truth lies somewhere in the middle. High volatility portfolios are perfectly valid, but you have to understand how much of their performance is attributable to fundamentals rather than marketwide trends. You wouldn't want to develop overconfidence that your positions are winners if they are simply time bombs that will explode spectacularly during the next crash. That's why professionals often use metrics such as the Sharpe ratio to analyze their strategies.
The amount of risk you're willing to take with your hard-earned capital is up to you, but you should be appropriately compensated for any risk that you're taking. For two portfolios with identical returns, the one achieved with less volatility is superior. Have a measured approach to volatility, and ensure that your upside potential is worth the risk.