These prejudices that make your life difficult

In the stock market, as in life, we are constantly confronted with prejudices. These come from our culture, our education, the media, our experiences, our fears, our greed, whatever. They push us to act most of the time irrationally, and therefore make us make mistakes. I provide some of them below, trying to understand them and protect ourselves from them.

Prejudice #1: Investing in the stock market is risky

This belief comes from the losses that many investors (including perhaps ourselves) have suffered in the past, during some major crashes or historical bear markets. We are obviously thinking of 1929, 1987, 2000 and 2008, but there are many others. Some small savers, but also much larger players, lost everything or almost everything during these events. Even if there is some truth, this prejudice leads us to remain completely on the sidelines of the market, which makes us run another much more pernicious risk: the loss of purchasing power due to inflation. By leaving your money in a savings account, you are indeed certainly losing money in real terms in the long term. Of course, in the short term, the stock market is riskier. But in the long term it is the only effective way to increase the value of your capital. To reduce the risk of investing in stocks, you need to diversify, buy cheap, invest regularly and have an investment horizon of at least 10 years.

Prejudice #2: Investing in the stock market is complicated

Thirty years ago, it's true that it wasn't easy to invest in the stock market. The Internet and ETFs didn't exist. So you had to get your information from specialist magazines and newspapers, then call your banker to place an order. Today, the web is full of information (relevant or not) and you can trade a stock in just a few clicks, at low cost. But the basic rule for investing has never changed and ultimately remains quite simple: buy a stock that is cheap compared to its intrinsic value. Depending on the method you use to determine this value, it's true that it can become complicated, but you can also easily accommodate a single indicator, as several studies have proven. Even a very simple strategy, consisting of only buying stocks with the lowest EBIT/Enterprise Value ratios, can beat investment funds, even though they are managed by so-called experts in the field. If you don't want to bother, you can simply buy an ETF that replicates the market. It couldn't be simpler, and since most people don't get better results than Mr. Market anyway, this strategy makes perfect sense as well. As always, the best is the enemy of the good. In the stock market, as in the local market, you just have to buy at a good price. If you start to complicate things too much, or to see them as more complicated than they really are, then there's a good chance that your life as an investor will become complicated.

Prejudice #3: A stock becomes cheap if its price collapses

Ask 100 people how to judge if a stock is cheap and 99 will tell you that you just have to look at its price history. If the stock is at its lowest in 12 months, or has lost a third of its value, for example, it is because it is "necessarily a good opportunity at this price" or it "cannot go any lower". Unfortunately, stock market history is full of companies that started by losing a few dozen percentage points, before going bankrupt. In Switzerland, we even had a textbook case in this matter, with the disappearance of Swissair. How many suckers, including yours truly, have been trapped by thinking they were buying a bargain when the airline was heading straight for ruin? As the saying goes, "You can't catch a falling knife". This is without a doubt one of the most valuable lessons I learned the hard way during my early years of investing. The history of stock prices has absolutely nothing to do with the value of a company. If the price falls at any given time, it is because the market believes, rightly or wrongly, that the company has lost its value. If it is right, as with Swissair, then the opportunity turns into a trap. Conversely, even if the market is wrong, it is not certain that the price, despite the fall, reflects the intrinsic value of the company. It is only the latter that should dictate our choices. Moreover, the market can take several years to recognize its mistakes.

Prejudice #4: A stock becomes expensive if its price rises sharply

If we assume that a stock is cheap when its price collapses, then the reverse would also be true: a stock that has gained 50% in a few months must necessarily be too expensive. But again: too expensive compared to what? It is not because the market is recognizing its mistakes, because it has disdained a company too much, that it has caught up with all the delay in terms of valuation. If you estimate that a stock is worth 100$ and its price has recently risen from 50$ to 75$, then you can still expect a nice capital gain by buying it at this price. Better still: you do not have to wait for the market to become interested in the stock you covet, because it is already getting carried away.

Myth #5: Big companies are safer than small ones

We have talked about Swissair, but we could also mention Kodak, General Motors, Enron and Lehman Brothers. Large companies are certainly more diversified most of the time and also benefit from easier access to credit. On the contrary, they are much more difficult to manage and develop. The problems to be dealt with in small companies are relatively simple and well-known. In big caps, they are complex and sometimes detected too late. Large companies have difficulty adapting to rapid changes in the social, technical, economic, political and ecological environment. They also have difficulty in innovating, renewing themselves and therefore growing. Small caps certainly have the opposite risk: they are not always strong enough to get through temporary difficulties. By taking a few precautions when reading the balance sheets of these companies, we can nevertheless ensure that they will be sufficiently equipped to do so. For large companies, it is much more difficult to judge objectively whether they have the qualities necessary to last. We must assess criteria that are less quantitative or financial, but more strategic, human, managerial and technical. In any case, it is wrong to think that they offer more security than small ones.

Prejudice #6: The market is efficient

This is more than a prejudice, it has even become a theory. However, you don't need to have attended HEC to see that this statement is totally wrong. Speculative bubbles have always existed, we even have a fairly recent case study in 2000 with Internet stocks. If the market were truly efficient, it would not allow the price of companies that have never created the slightest profit to soar into the firmament. Nor would it allow, following the long bear market that followed, other very good quality stocks to be totally neglected. Along the same lines, if the market were truly efficient, how is it that a certain number of investors, part of the Benjamin Graham school, have managed to beat it year after year, for a very long time? The market, in the short term, is anything but efficient. It reacts according to the fears and greed of the human beings who interact with it. In the long term, however, it does indeed always end up returning to its true value.

Prejudice #7: Analysts know more than we do

Analysts obviously have access to an incalculable amount of privileged information. They have the time to conduct extensive research on a particular company. So yes, from this point of view, they know more than we do. The right question to ask yourself, however, is: is this information useful and relevant to obtain better performance while minimizing risk? The answer is no. Analysts all have one or more biases. The first is that they come from the financial world. They therefore have difficulty thinking "Out of the Box". The best example was provided to us in 2008 with the subprime crisis. The other bias of analysts is their frequent focus on short-term results, particularly quarterly results. In doing so, they participate in market volatility by issuing recommendations or earnings forecasts. Let us also obviously mention the obvious conflicts of interest to which they are subject. So, yes, analysts potentially know more than we do, but this information only serves their own interests. On the contrary, by thinking outside the system, we have every chance on our side to do better than them.

Prejudice #8: Only the very rich can make money in the stock market

Having a substantial starting capital undeniably offers several advantages for investing in the stock market. The larger our assets, the more we can diversify our assets. In addition, by buying large positions, we limit the proportion of transaction fees. However, it has been proven that beyond 50 positions, diversification no longer offers any advantage. In addition, these days, we can find really cheap brokers, even for small transactions. When we have a small fortune, it is relatively easy to find opportunities to invest in. On the contrary, with a large amount of cash, we have to rack our brains to find more and more places to invest our money. We can certainly use financial specialists, but they obviously charge additional fees, and as we have just seen, they are not necessarily better than us.

Myth #9: A stock that pays a big dividend is cheap.

It's so tempting... You come across a stock that pays a yield higher than 5% and you think to yourself that it's a great deal. In doing so, you forget that dividends, unlike bond coupons, are not guaranteed. A company can absolutely reduce or even eliminate the distributions it offers to its shareholders. On the contrary, a company that pays a very small dividend can decide to double it the following year. Basing itself on the dividend to know whether a stock is cheap or not is therefore a very bad idea.

Myth #10: Mutual funds are safer than stocks

It's quite the opposite! As we saw in prejudice #2, even by betting on a very simple strategy, it is possible to obtain better performance than investment funds. You just need to diversify your portfolio sufficiently to prevent it from being too volatile. Between 20 and 50 stocks will do the trick. By betting on an investment fund, you inevitably lose between 1% and 2% per year, just to pay those who take care of it. That's a lot compared to a real profitability of around 8% that you could obtain per year on the stock market. Don't forget: any intermediary will necessarily take their share of the cake. By buying stocks directly, you avoid this problem. Not to mention that you are certain that the strategy suits you. ETFs are more interesting than investment funds, because of their low management fees. Be careful though because ETFs have a bias towards "popularity" (to the detriment of quality), namely big caps and large stock markets. In addition, they have an unfortunate tendency to lend the shares they own ("securities lending"), in order to artificially lower their fees. This practice is not without risks. Some even say that this rather opaque strategy of ETFs has the potential to trigger a crisis comparable to that of subprimes!