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Stock Market Myths

The following is a guest post from Ben Carlson at A Wealth of Common Sense. Ben writes about personal finance, investments, investor psychology and using your common sense to build wealth.

Investing is counterintuitive.  It’s one of the reasons that investors get into trouble by paying attention to the wrong factors when making decisions.  In light of this, here are three stock market myths to consider.

Myth #1: The Economy Must be Strong for Stocks to Perform Well

Most investors think that forecasting economic activity is a prerequisite for achieving good stock returns.  Recently we have seen slow global economic growth with high rates of unemployment in many countries.  Many see this economic data and assume that stocks should be doing terribly.

But anyone who has paid attention to global stock markets for the past five years knows that this is not the case.  Economic growth has been anemic yet many stocks have performed remarkably well, doubling or more in some global markets.

Multiple studies have shown that the majority of the time, stocks and economic activity have little to no correlation in the short or intermediate term.  Over the long-term there is a relationship between stock earnings growth and nominal GDP but trying to make investment decisions based on economic growth projections is ineffective.

In fact, a recent article in The Economist discussed a study that looked at the 1972 to 2009 period and ranked countries by GDP growth over the previous five years. Investing each year in the countries with the highest economic growth over the previous five years earned an annual return of 18.4%, but investing in the lowest-growth countries returned 25.1%.

According to NBER, since the Great Depression, the US economy has been in a recession for almost 13 years or 15% of the time.  Yet in that time frame, stocks are still up almost 10% per year.

Myth #2: High Unemployment is Bad for Stocks

An offshoot on the economic growth myth is the fact that investors see high rates of unemployment in most countries and think that this has to lead to poor stock performance.

The line of thinking goes because more people are out of work, spending decreases, which leads to lower revenues for companies and therefore lower stock prices.  Historical data shows that this is another false assumption.

Consider first, the start of the 30-plus year bull market for stocks in the early 1980s was at a time of double digit unemployment in the US and a pretty nasty recession.  Next, consider with a 25% unemployment rate during the Great Depression, stocks had their single best three-year period on record.  Last, since 1951, the best twelve month returns were in periods following an 8% unemployment rate.  Conversely, the worst stock returns have actually occurred following 4% unemployment.

One of the reasons for this is the fact the unemployment is largely is a lagging indicator.  It tells us what happened in the past, not what is going to happen in the future.

Myth #3: Stocks are More Volatile than Bonds

In the short-term this is correct.  Stocks have had multiple declines of 20% or more in fairly short periods of time.  I’m sure we’ve all had large losses in our equity investments at one time or another.  But when you look at the long-term data this myth doesn’t hold up.  Take a look at the volatility (standard deviation) of the rolling returns for stocks and bonds since 1928:

Rolling

 

As you can see, the longer your time horizon, the lower the volatility for stock returns.  Over rolling 30 year periods, the volatility of returns for stocks is actually lower than it is for bonds.  Hard to believe, but true.

The Takeaway

You don’t necessarily need to pay attention to the economy or short-term investment results when you make your decisions.  Instead, think long-term and simply focus on the factors that you can control.  Investing for the long-term can break all kinds of myths.

Thanks to Ben for his contributions to My Own Advisor.  Any other stock market myths to bust?

Filed in: Stocks

12 Responses to "Stock Market Myths"

  1. What’s funny is that myth 1 and 2 are pretty much the same thing. When the outlook is the brightest is usually when stocks are overvalued and therefore expensive and ready to decline. The best returns are found through buying quality companies whenever everyone thinks the economy is never going to get better i.e. low growth and high unemployment.

    Since the Fed started allowing the rate to float, the volatility in bonds has gone way up. In general bonds will be less volatile but not by nearly the margin that most people assume. I think if you’re going to own bonds the best route is to own individual bonds because you aren’t subject to the whims of all the other investors bringing down the MF/ETFs due to fears about the bond market. Of course then you have to worry about being properly diversified. It’s much harder to do purchasing individual bonds.

  2. Ben says:

    Yeah, the first two are fairly similar. It’s just hard for people to grasp because most people are looking for a green light. The other thing to learn from those two is that using economic data points as investment indicators is overrated.

    Another point about bonds that not many investors realize is that volatility is heightened at lower rates. There’s a big difference between interest rates going from 2% to 3% vs. 7% to 8% even though it’s the same absolute value.

    They actually are now starting to offer ETFs with set end dates so you can get diversification along with the benefits of having a maturity date to decrease your risk and plan out your liabilities. @JC @ Passive-Income-Pursuit

  3. Wonderman says:

    “…think long-term and simply focus on the factors that you can control.”

    Exactly which factors of the stock market can you control (aside from buying and selling)?

    • You can control…a) your investing behaviour, b) you can optimize your tax situation with investments and c) you can control your investment fees.

      You can do nothing, unfortunately, about the returns you will receive.

      Thanks for asking, a good question.

  4. Ben says:

    I agree with Mark and I would add that you control how much you save and when you make those buy and sell decisions. My point was that you can’t control the stock market or the economy so you need to focus on the moves that you have some say in.

    • If ONLY we could control the economy? :) My order of what I can control: 1) investing behaviour 2) fees 3) taxes. I figure if I can consistent nail all three over my investing career, I’ll do very, very well.

  5. Stock Market Future says:

    It seems their are many myths which explained in blog about share market which gives many investors to invest in share market.Thanks

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