Everyone is looking for an easy way to make money. The stock market has delivered some impressive returns over the years. Many people make money and many lose money. Let us look at some myths and realities about investing that clients should understand.
1. Myth: The stock market always goes up. If you look at the Ibbotson mountain chart, the US stock market has risen for decades, over 10% a year on average since 1925. There is no risk.
Reality: Stocks sell at a multiple of earnings, the price/earnings ratio. Assuming the PE stays constant, when earnings increase, stock prices increase. Rising prices year over year requires continuous growth in earnings. If earnings decline, stock prices go down. Two consecutive quarters of GDP declines is considered a recession.
2. Myth: Companies do not need to have earnings. A good idea is all you need. This ties into the New Economy thinking of the late 1990’s, but we see it again today. The concept ties in the “If you built it they will come” concept. Either the world will beat a path to your door or a big company will buy out the little company that has that great idea.
Reality: Investors want their money back plus a healthy profit. The Dot.Com bubble burst in March 2000 when the markets decided earnings did matter after all. Stocks are valued on PE multiples.
3. Myth: Money put into savings in a bank is guaranteed. This logic is based on the concept of FDIC deposit insurance, which protects you up to $250,000 per depositor. This is true for US banks covered by FDIC insurance.
Reality: Not all banks are in the US. There are banks all around the world. Some have great names and impressive buildings, but are operating overseas, not in the US. They might be in the Caribbean. They might offer interest rates that seem too good to be true, but if they aren’t in the US, they are not guaranteed by the FDIC.
4. Myth: The smartest way to invest is by using OPM or Other People’s Money. This is the logic behind investment vehicles like hedge funds which use a 2+20 formula. They get 2% in fees to run the fund and 20% of profits over a certain threshold.
Reality: Because the average investor cannot setup their own hedge fund, the next best thing might be buying on margin. You put up your own money, borrow more money from a brokerage firm and buy stock. If the stock goes up, you sell, repay the loan plus interest and keep the rest for yourself. The OPM dream becomes a nightmare when stocks go down. All the losses are felt on your side of the ledger. The loan never goes down until you repay it.
5. Myth: Dividends are a little bonus that does not need to be reinvested. You buy stock. You see the price change every day. Some shares pay out cash quarterly. The amounts are often so small, they look like they hardly matter.
Reality: Reinvesting dividends delivers the compounding effect when considering total return. According to CNBC, since 1945, dividend reinvestment contributed 33% of the overall return of the S&P 500 index.
6. Myth: You can’t lose money if you buy a product sold by a bank. This might have been true decades ago when banks took in deposits, made loans and that was it. Later, banks started selling investment securities like mutual funds and bonds to the general public through financial advisors.
Reality: Decades ago, some people might have assumed everything you bought through a bank was guaranteed by the FDIC. They are careful today to differentiate between savings vehicles and investments, often sold by two separate organizations.
7. Myth: If I don’t start saving early, I can always catch up. This works on the logic retirement is so far in the future, twentysomething investors can put that pot on the back burner.
Reality: There’s an expression, “It’s not about timing the market, it is time in the market.” The government might let people who delayed saving for retirement to make catch up contributions, but the extra amount they can put away is far less than the amount they would have saved if they contributed on a regular basis.
8. Myth: Market timing works. People assume this is what the experts do. The smart money is constantly in and out of the market.
Reality: It is not possible to consistently time the stock market because you run the risk of missing the best days. CNBC reported if you consider the decade starting in 2010 and were continuously invested, your return was 190%. If you excluded the ten best days, your return fell to 95%.
9. Myth: If the stock market has historically returned 10% a year, then 10% is a realistic retirement savings withdrawal rate. The logic seems simple. If everything works well, you would never invade your principal. What could possibly go wrong?
Reality: The stock market might have returned that number over time, but it doesn’t return 10% every year. Some years it returns less. Some years it has negative returns. Those negative returns can be back-to-back. The retiree would be withdrawing 10%, probably the same dollar amount as when they started, every year. When you have bad years, the base for future growth declines dramatically. Experts have felt 4%-5% is a more appropriate withdrawal rate.
10. Myth: All government debt is safe. We know a US Treasury bond held to maturity returns the original principal amount. We know countries like the United Kingdom, France and Germany issue bonds too. Government bonds are called sovereign debt. We feel pretty confident the Brits, French and Germans would honor their debts, therefore we assume all government bonds are equally safe.
Reality: Not all governments are solvent. Not all governments treat money owed to others with the same respect. Argentina and Lebanon are two recognizable country names that have defaulted on their debt in past years.
Investing often looks easy. People should go in with their eyes open. They should take advantage of some level of professional advice.
Bryce Sanders is president of Perceptive Business Solutions Inc. He provides high-net-worth client acquisition training for the financial services industry. His book, “Captivating the Wealthy Investor,” is available on Amazon.