Four market myths that continue to mislead but motivate investors

Folk wisdom is full of gems on supply and demand. But beware: they are based on faulty logic

Traders on the floor of the New York Stock Exchange: many market nuggets are more likely to mislead than to enlighten. Photograph: Jin Lee/Bloomberg

Traders on the floor of the New York Stock Exchange: many market nuggets are more likely to mislead than to enlighten. Photograph: Jin Lee/Bloomberg

Tue, Jul 1, 2014, 12:39

A question: what do the following statements all have in common? Rising earnings are good for stock markets, as are improving economic growth figures. Two heads are better than one, which is why investment clubs deliver better returns. The best investors are those who successfully forecast the financial markets.

Answer: each statement sounds like a statement of the obvious, but is in fact completely untrue.

Myth 1

Rising earnings drive equity returns

Rising earnings are good for stock markets; declining earnings spell declining returns. Additionally, stock markets perform better when indices trade on low earnings multiples.

This seems like common-sense advice, but the relationship between earnings and markets is not nearly that simple. Examining 65 years of market data, trader and Practical Speculation author Victor Niederhoffer found that earnings rose on 43 occasions and saw 22 annual decreases.

Markets rose an average of 4.9 per cent during the rising years, compared to 14.2 per cent in years of declining earnings.

Similarly, while commentators will often justify their bullish or bearish position by pointing to one year price/earnings valuations, these have no predictive merit. At the beginning of 1929, prior to the market crash, US markets traded on less than 18 times trailing earnings.

They traded for 17 times earnings in 1933, a year which saw indices soar 50 per cent, the first year of a strong cyclical bull market.

Markets also traded on a higher price/earnings ratio in 2003 (the early stages of a five-year bull market) than in 2000 (just prior to a bear market that saw indices halve).

In January 2007, prior to the global financial crash, the S&P 500 traded for 17 times earnings; it traded for 71 times earnings in January 2009, near the bottom of the global bear market.

As Niederhoffer notes, earnings fallacies have “an appealing, superficial plausibility”, but these neat little nuggets are more likely to mislead than to enlighten.

Myth 2

Investment clubs deliver the goods

If two heads are better than one, then surely investment clubs are a source of education and juicier returns – right?

Well, no. The investment club concept gained popularity in the 1990s, when the US-based Beardstown Ladies – an investment club mainly made up of 70-something women – released a bestselling book detailing how they apparently beat the market over a long period. It later emerged that they got the maths wrong and had in fact substantially underperformed the market.

So do most clubs. One study, Too Many Cooks Spoil the Profits, examined the performance of 166 investment clubs between 1991 and 1997, and found club members overtraded, favoured volatile growth stocks and ultimately underperformed the market by almost four percentage points per year.

Even worse, they underperformed individual investors by two percentage points per year. The club members would have been better off on their own.

Discussing groups in general, investment strategist James Montier writes that the “eternal hope” is that they will “come together, exchange ideas, each bringing something different to the discussion”.

However, members tend to “abandon their individual information, choosing to agree with others, because they think they know more”, and ultimately groups “amplify rather than alleviate the problems of decision-making”.

Of course, investment clubs, as the aforementioned study concluded, have their uses. “They encourage savings. They educate their members about financial matters. They foster friendships and social ties. They entertain. Unfortunately, their investments do not beat the market.”

Myth 3

Economic growth is crucial to stock returns

Fast economic growth is good for stock returns; slow growth is bad.

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