Five Investment Fallacies

Five Investment Fallacies

Over my many years as a financial planner I’ve pretty much heard it all when it comes to investment beliefs and expectations. Here are five of the more interesting investment fallacies I’ve encountered.

A stock split is a buy signal (false).  A stock split is nothing more than a company’s attempt to reduce the price of a single share of its stock, typically to encourage more buyers. For example, a 1:1 split by a company with one million shares outstanding priced at $100 each would result in two million shares outstanding, each with a price of $50. It does not change the company’s capitalization market value (number of shares times price per share), nor does it reflect any change to the company’s profitability. There’s also no evidence that stock a split in the absence of any other company event results in higher valuations over time.

When the S&P 500 rises it means all companies in the index rise (false). Basic math tells us that even if only half the stocks of any index increase on any particular day, the index can still increase as long as the total rising stock amount exceeds the losses from the losing half. The S&P 500 in particular can easily rise even when a large majority of stocks comprising it are falling because it is capitalization-weighted, meaning companies with higher market capitalizations have a more pronounced impact on the index. Apple alone, for example, represents about 6% of the S&P 500, while Under Armour’s weighting equates to less than a tenth of a percent. If the prices of only the top twenty stocks increased on a particular day, the index could still rise even if the remaining 480 declined.  

A company’s share price growth always reflects its earnings growth (false). While earnings growth is one primary factor influencing a stock’s price growth, the other factor, investor sentiment, can have a much greater impact on stock price movements. We see this all the time during quarterly earnings announcements. When a company’s reported earnings growth and/or earnings projections do not meet investor expectations, the stock price invariably falls no matter how stellar the company’s bottom-line performance had been.

Bond prices always rise when stocks prices fall (false). This misunderstanding may be related to the fact that the correlation between these two asset classes tends to be low. (Correlation is the degree to which the prices of two investments move in the same direction and by the same amount). The correlation between the two would have to be negative in order for bond prices always to move in the opposite direction of stock prices. And you wouldn’t want to own two assets whose correlation was 100% negative because any growth from one would be completely cancelled out by the other. Having a correlation of zero between asset classes is ideal for an investment portfolio.

Chart gaps are always filled (false). This comes from the proponents of technical analysis who believe that you can predict future stock prices based on patterns of previous price movements. A gap is when the range of a stock’s price on a particular day does not overlap with its price range on the previous day (in other words there’s a gap between its high on one day and its low on the next, or vice-versa). Technical analysts believe that the stock’s price will always return to cover such a gap at some point in the future. If the gap is below the stock’s current price, the price will eventually fall, and vice-versa.

And to those investors who believe they can predict market tops and bottoms and/or pick stocks that will outperform the rest, I remind you of Yogi Berra’s well-known aphorism: “It’s hard to make predictions. Especially about the future.”

Leave a Reply

Your email address will not be published. Required fields are marked *

This site uses Akismet to reduce spam. Learn how your comment data is processed.