Halloween is upon us, and soon we will close the books on another year of investing.
It’s been quite a hair-raising run for stocks in 2015 thus far, with the S&P 500 up slightly on the year but seeing plenty of volatility in both directions. But as investors take stock of where we’ve been and speculate where their portfolios are headed in the next 12 months, it’s important they keep their emotions in check.
Now, more than ever, getting spooked can really cost you.
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Many Americans get taken in by the sneaky tricks of Wall Street fat cats — or just as bad, let high-pressure scare tactics affect their behavior. So as you look to forge your investing plan through the end of the year and into 2016, here are some evil investing tricks to look out for:
Invasion of the Penny Stocks
The Trick: Cheap stocks are the best investments because you can buy a lot of shares! Not only that, but you make money faster, because if a stock goes from one penny to two pennies, it doubles. A $50 stock needs to add another $50 for those kinds of returns, but adding a cent or two is much easier.
The Truth: Share price doesn’t matter. Stocks appreciate because the underlying business is good, plain and simple.
Let’s say you invest $10 million in a company. Whether you buy 100 million shares at 10 cents each or 1 million shares at $10, your stake is the same. If the stock does well and becomes worth $20 million, you doubled your money regardless — it’s just that in the former example, your 100 million shares would be valued at 20 cents, and the latter your 1 million shares would be $20.
The most important part of that math, however, is that the stock does well and the overall company rises in value. This is much more important than nominal share price.
It’s also a myth that cheap stocks go up “faster.” Consider Priceline.com (PCLN), which traded for over $400 a share in 2010. It now it trades for more than three times that, at around $1,300. Not bad for an “expensive” stock.
Vile Valuation Metrics
The Trick: According to cyclically adjusted price-to-earnings ratios (or whatever other metric is in fashion), the stock market is clearly overvalued … and thus, ready to crash.
Or conversely: This stock is grossly undervalued based on next year’s predicted sales and earnings growth, and is therefore a guaranteed winner!
The Truth: For starters, there is no magic number for calculating the fair value of a stock. While we all have our favorite measures, the fact is that P/E or debt-to-equity ratios only tell us part of the story.
After all, if P/E ratios were everything, any company that was unprofitable would therefore be worthless. Squishy measures such as confidence in management, the quality of a company’s brand or the potential of research and innovation count for something — and in the case of certain companies like development-phase biopharmaceutical companies or tech startups, these measures count for a great deal.
It’s always good to look at the cold, hard facts of an annual report. But it’s also naïve to think that the true value of a company can be calculated with one simple equation.
The Trick: Sell in May and go away… then buy stocks later for the annual Santa Claus rally to end the year!
The Truth: While statistics indeed show that some months are stronger than others, with November through January generally offering better historic returns, it’s crucial to note that winter months are not immune to market meltdowns.
Just look back a few years to the mayhem of 2008, where November saw a 7.5% decline or so over 30 days, or 2009 when January logged an 8.5% monthly decline.
Timing the market is impossible, whether you’re moving your money based on the calendar or on macroeconomic indicators. A long-term strategy of staying invested not only generates better returns, but also cuts down dramatically on your fees.
Bloated Buybacks From Beyond
The Truth: Simply because a company buys back its own stock by the boatload doesn’t mean it’s destined for a rally.
For instance, Qualcomm (QCOM) and AT&T (T) have both been buying back stock aggressively and their share prices have languished – or more broadly, data shows a staggering $589 billion was spent on stock buybacks in 2007 … and stocks barely budged on the calendar year, then crashed and burned in 2008.
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Furthermore, cash spent on buybacks is money that isn’t spent on research, acquisitions or expansion of the business. In theory, taking shares off the market can help share prices … but as with everything, the underlying profits and sales of a stock are far more important.
Blood-Sucking Management Fees
The Trick: My money manager may charge more than some, but he’s the best and will earn his fees.
The Truth: Passive funds with lower fees almost universally outperform active funds and active money managers in the long run. That’s because if the stock market as a whole does 7% annually, a manager that charges an extra 1% in fees on your portfolio will have to deliver 8% annually — a significant premium, and one they have to deliver every single year.
That’s just not possible. In fact, Warren Buffett himself recommends low-cost index funds for most retail investors because of this.
There may be the occasional exception, but long-term investing with an eye on low costs is the best way to go for the vast majority of investors.
The Trick: This stock yields 6% annually in dividends. Even if it goes nowhere, that’s a great return on my investment!
The Truth: Dividends themselves are a share of profits paid back to shareholders, and companies don’t distribute them lightly.
Dividend yield, on the other hand, is different. It’s the percentage of your initial investment you’ll get back each year at the current rate of dividends.
If you simply look at the yield, you may be fooled into thinking a stock is a good investment. But if the actual dividend itself is unsustainable and at risk of being cut, the yield at the time you purchased may not matter much.
Furthermore, there are two ways that dividend yield goes up — either because dividends are rising, or because share prices are falling. Make sure your big yield is a function of the former scenario, and not the latter.
The IPO Illusion
The Trick: Get in on the ground floor of this hot new company and watch the profits roll in!
The Truth: When you hear about big first-day moves like Alibaba’s (BABA) 38% pop or Twitter’s (TWTR) 73% surge, realize that normal investors don’t have any chance of enjoying those gains. Those rewards go to those who invested early, before the company went private.
In fact, after an IPO, these investors make money by selling, not buying … and the person they sell to is you.
Not every company that comes public is destined for great long-term success, either. Others that do stick around are simply overvalued at the time of their IPO because the market doesn’t know enough to value the company properly.
In both cases, buying right away will mean that you’re left holding the bag if and when those stocks implode … just like Alibaba and Twitter have lately, despite their “successful” initial IPOs.
It’s better to do the research and be patient, and treat recently issued stocks as aggressive and untested buys instead of sure things.