Anything that's driven by numbers can degrade into a carnival of the ridiculous without much effort. Sadly, the stock market is no exception. It's loaded with common myths -- the so-called rules of thumb for when and how to invest. But really, do any of them work as advertised? Let's put three myths to the Foolish test.
Myth No. 1: Stocks that split always go up
This rule of thumb says that stocks that split -- or increase the number of available shares to lower the price per share -- go up because the stock appears to be cheaper. But that's a psych-out; it's like an 18-inch pizza sliced into 16 instead of eight pieces. The total value of a firm doesn't change with a split.
Splits don't much matter for returns, either. Take Berkshire Hathaway (NYSE:BRKa), for example. The shares have never split, but my copy of the annual report says the stock has returned more than 20% annually since 1965. And what about Google (NASDAQ:GOOG)? It has yet to split and doesn't seem to be in a hurry to, either. Has that hurt returns? Hardly.
Consider also that firms sometimes see heady declines after splitting their shares. Let's take a look at Pulte Homes (NYSE:PHM) and Ameristar Casinos (NASDAQ:ASCA). Both split their stock 2-for-1 last year, yet the shares of both are down more than 20% over the trailing 12 months.
The truth: Stock splits don't affect returns.
Myth No. 2: An increased dividend means you should buy, buy, buy
We're in part responsible for this rule of thumb, which says that stocks that increase their dividends are headed north. It's a logical conclusion; stocks that boost dividends tend to be increasing cash flow. And such firms can be attractive to investors.
Some firms aren't above gimmicks, such as taking on debt to fund dividend increases. For example, Woolworth's was a budding empire at the time it constructed the Woolworth Building in 1913 New York, but management spent years paying a dividend it couldn't fund through organic cash flow. Today, Woolworth's is no more -- done in, at least in part, by a loony dividend policy.
Questionable judgment persists today. Consider Tribune (NYSE:TRB), which has boosted its dividend by almost 18% annually in the past three years. The perky payout, which yields 2.4% as of this writing, appears aimed at appeasing investors hungry for returns stolen by scandals and dwindling newspaper circulation. The ploy hasn't worked. Tribune's stock is down roughly 39%, and the underlying business has worsened; cash from operations has declined substantially since 2003.
Myth No. 3: Insider selling often foreshadows trouble
This final rule of thumb says that investors should bail out as soon as insiders begin to sell shares. Never sail with a sinking ship, as the thinking goes. That's smart, right?
Not exactly. Legendary investor Peter Lynch has been known to say that insiders sell for many reasons, often to diversify or fund large purchases. That makes drawing conclusions from such transactions a little like reading tea leaves. You might think you're an expert, but in the end, you're just guessing.
And in doing so, you may be leaving huge profits on the table. Consider Hansen Natural (NASDAQ:HANS); last June, vice president Michael Schott sold more than $400,000 worth of shares. Had he waited until now, his stake would have nearly quadrupled. (Whoops.)
Don't break your thumbs, or your portfolio
Market mythology is useless. Focus on the business instead. Know a stock, and understand the context around splits, dividend increases (or initiations), and insider selling. That's how David and Tom Gardner approach every stock they recommend (and re-recommend, sometimes over and over again) each month in Motley Fool Stock Advisor.
For example, David has recommended Marvel Entertainment (NYSE:MVL) three times to subscribers of the service, twice before and once after the 3-for-2 split in March 2004. In exactly none of those recommendations did David consider a potential split germane to his thesis. And for the record, while all three picks are market-beaters, it's the first two pre-split selections that have become multibaggers.
All told, David and Tom are beating the S&P 500's average return by more than 30 percentage points. Want to find out how? Try the service for 30 days. The timing couldn't be better: Tom recently reviewed all past picks on his side of the scorecard, urging readers to buy, hold, or sell -- and explaining why. With your free pass you'll gain instant access to this and all features of the Stock Advisor service. As always, there's no obligation to buy.
Fool contributor Tim Beyers used to be huge at thumb war. Ameristar Casinos is a Hidden Gems recommendation. Tim owns shares of Berkshire Hathaway. You can find out what else is in his portfolio by checking his Foolprofile. The Motley Fool has an ironcladdisclosure policy.
