5 Myths About Investing cont'd
by: Dr. Boyce Watkins

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Myth #3) The stock market is one of the best places to make money

The stock market is not a great place to make money, at least not in the short-run.  It is a great place to keep the money you’ve already made.  Don’t get me wrong.  There are many people who’ve made their fortunes trading stocks, but that is not the norm.  Additionally, even though there are many who’ve made a fortune trading stocks, there are many more who’ve made their fortunes through other investments.  The stock market is what they call an “efficient market”, in which it’s hard to find underpriced assets.  This is a lot different from some other markets, where you can find a pretty good deal if you look hard enough.

When looking for a place to invest your money first, you should start with the investments that offer the highest return for the lowest risk.  That means things that you are familiar with that can help you make a lot of money with very little uncertainty.  One place to start might be with an investment in YOUR SELF.  Do you enough education to have the kind of career you would like?  How about going back to school for that college degree or MBA?  In my own research, I have determined that the returns to this kind of investing far exceed the returns generated from the stock market or other places.

Other places to consider investing might be in Real Estate or perhaps in the business of a relative.  If you have a friend that is going into business, and you have reason to believe that this person is fulfilling an unmet need, has a guaranteed customer base, and is reliably going to give you your money back, then this kind of investment might be better than going right to the stock market.

You can also make a lot of money by saving money.  Let’s say that you have a credit card that charges you 15% interest with a balance of $10,000.  Assume you have an extra $10,000 available for investment.  Also assume that you expect to earn 10% on the stock market (roughly what the US stock market earned during the 1997 – 2001 time period).  There are two things you must remember about this investment:

1)      The amount you are paying on your credit cards is greater than what you would earn from the stock market.

2)      The amount you would earn from the stock market is risky, so it could be higher or lower than the average.  The amount you are paying on your credit card is going to be the same, no matter what.

So, you have two choices:  You can either a) invest the $10,000 in the stock market, earning an average of 10%, or you can b) Use the money to pay off your credit cards, keeping you from having to pay 15% interest.  If you go with option a) (investing in the stock market) and assume that you are guaranteed 10% on your money, you will earn $1,000 and have to pay $1500 in credit card interest (15% x $10,000).  This leads to a net loss of $500. 

If you go with option b) (paying off the credit cards and not investing in the stock market), you can save $1500.  So, there is a $2,000 ($1500 – (-$500)) difference between these two choices.

The point is simple:  As they say, “A penny saved is a penny earned”.  You can also say “A penny not paid in interest is a penny earned in interest.”  By using the money to pay off high interest debt, you have found one of the best investments around.

The point of all this is that investing in the stock market is nice and glamorous, but it’s not the way to make money.  If you really want to make money, you should start with investments around you:  Buying a home, paying off credit cards, or going back to school.  These investments give higher returns than the stock market. 

Myth #4) Putting all your eggs in one basket might be OK

“Diversification” is an important investment concept that most investors do not think about.  It is the idea that you should not put all your eggs in one basket when investing.  Many investors do not follow this rule, instead putting all of their money in one place.  This is a BAD idea!  Consider the employees at Enron (the company that went bankrupt a few years ago).  Some of the Enron employees had their entire retirement plan with one company.  Many of these people lost their life savings when the company went bankrupt.   

Every good thing eventually comes to an end, and if you are properly diversified, you are protected when things really do fall apart with your investments.  Diversification means that you not only buy a large selection of stocks, but you keep your money in different types of investments.  For example, if a person has a portfolio to invest, they should keep a few thousand in different kinds of stock, some of the money in their savings account for a rainy day, some of the money in real estate, and some of it in the family business.  Spreading your money around protects you well when things go bad in the market. 

Another thing about investing is that it should be GLOBAL.  If you buy a portfolio of stocks, you do not want to have your money focused on the United States.  There are mutual funds which allow you to invest all over the world, where many of the best opportunities are.  Make sure that you are diversified across boarders, so if one country’s market fails, you will have investments all over the world to protect you.

Myth #5) If a stock has done well in the past, it will continue to do well in the future

Most people think that if a stock has a good past performance, it is going to continue to be a good stock in the future.  All of my own academic research, as well as the academic research of many others, shows that this assumption is almost always WRONG.  There are some rare exceptions in special cases, but for the most part, the past performance of a stock or mutual fund manager is no indicator of what is going to happen in the future.

You see it all the time:  magazines will rank the best performing stocks, top industries, and best performing mutual fund managers.  This publicity is great for the fund manager, because he/she knows that most investors do not know the truth.  The truth is that when ranking investment managers and stocks on the prior year’s performance, there is almost no positive relationship between the performance of the past and that of the future.  Notice that I say “almost no positive relationship”.  That is because my research shows there are some rare cases in which there is some relationship, but this is not something worth betting the house on.  

The best way to invest in stocks is not to chase winners.  The best approach is to simply invest in solid companies for the long haul and keep your portfolio diversified.  If your portfolio is properly diversified and you leave money in your investments for several years, you will most likely find a natural growth which allows you to sleep at night.  Those who chase every hot stock down the street end up driving themselves nuts.

 

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