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When I wrote about income strategies, I started by debunking a couple of stock market myths. The first was that reinvested dividends comprise the bulk of stock market returns. (The truth is that both dividends and capital gains are roughly equal in their contribution to equity returns.) The second myth was that dividend growth investing is a good idea. The empirical evidence shows that investing for dividend growth is a strategy that underperforms simply buying the current highest-yielding stocks, which in turn, underperforms other popular value strategies. Dividend growth investing adds complexity and reduces performance. Believing the dividend growth myth has probably cost value investors more money over the years than many more obvious investing mistakes. I showed investors a better way to build an income strategy here.
Stock market myths don't just exist in income investing. Everyone has an inbuilt bias to believing myths. It comes from a gap between how people think they assess new information and how they actually do it.
This is how people believe they will react to hearing a novel fact:
They hear something.
They weigh up the evidence for and against the proposition.
Based on the evidence, they ultimately decide whether it is true.
However, the research of Harvard Psychology Professor Daniel Gilbert and others has shown that the process they actually follow is more like this:
They hear something.
They believe it.
They decide to vet it later, and sometimes not at all.
Anyone who has believed supposed maxims such as ‘eating carrots helps us see better in the dark’ or ‘there are seven dog years to a human year’ has fallen for this cognitive trap. They have heard and believed these statements because they sound plausible, despite no evidence of their truth. They never verified these and simply added them to their canon of ‘knowledge’. It is the same for many stock market beliefs as well. Here are just a few of them:
Everyone likes to track their impact on the world, so investors often look for their buy or sell to show up in the reported trades. In such feeds, transactions are allocated to a buy or sell column. Sometimes, a share purchase will be marked as a sale, and vice versa. When this happens, some investors believe it has been intentionally misreported to give a false picture of the underlying supply and demand.
The Truth: Every trade is a buy and a sell. Investors are trading either directly with another investor on the order book or with a Market Maker. The information the exchange publishes is just the time, price, volume and a code to indicate the type of trade. It is data processors that categorise these trades into buys or sells. They do this simply using the published bid and ask at the time of the transaction. Any trade price below the mid-price is marked as a sell and above as a buy. Investors who bought shares below the published mid-price should be thankful that they purchased stock cheaply and not worried that reporting has been manipulated.
Investors never like to hear that other investors are pessimistic about a company they hold. It’s even worse when a fund announces they are short (betting that the share price will fall) and makes serious allegations about the conduct of the company or management. Given that funds that short stocks may share ideas before going public with their concerns, some investors feel that this represents a conspiracy to manipulate the stock prices of otherwise healthy companies.
The Truth: Short-selling is difficult. Those who engage in this activity open themselves up to unlimited losses, short squeezes, and accusations of impropriety. In some cases, they are even followed by investigators hired by their target company. The investment industry is biased towards buying stocks since this is where most fees are generated. This bias permeates through to regulation, too. For example, with Wirecard, the German regulator BaFin investigated the journalists that found evidence of wrongdoing rather than the company or individuals committing the fraud. Given the inherent challenges in successfully shorting a company, people who short shares tend to be amongst the best-informed investors.
Short-sellers almost always aim to profit from releasing a negative report on a company. However, this isn’t any different from long-only investors who do a write-up on their favourite stock. Both are seeking to accelerate price discovery. As Warren Buffet famously said, “In the short term, the market is a voting machine; in the long term, a weighing machine.” A company facing severe problems or being dishonest will be “weighed” and found out eventually. So a critical report about a company that an investor owns should be welcomed. If the investor can prove the allegations false, they will likely be able to get a bargain as others sell. If the investor cannot refute the allegations, the report allows them to get out of the stock before a much worse collapse in the future.
Market Makers often have a bad reputation amongst individual investors. Many accuse them of manipulating market prices to profit from quirks of investor behaviour. For example, the idea of a “tree shake” is that investors will be scared into selling their shares by a rapid drop in price and that a Market Maker will induce this when they are short of stock.
The Truth: The markets are very well regulated, and as the following PI World interview with a former Market Maker explains, any form of market manipulation would not be allowed. While I sympathise with the view that Market Makers don’t always do a great job of providing liquidity (spreads can be wide, and Market Makers refuse to trade via electronic means during periods of volatility), they almost always reflect the underlying liquidity in the market. In virtually all cases, market Makers move their pricing to reflect their underlying book. Investors also need to remember that, in many cases, there are multiple Market Makers, so the ability of a single Market Maker to falsely move the price is severely limited.
The same goes for other Market Maker conspiracies, such as hunting for stops or single-digit share trade “codes”. Although savvy traders may know that investors like to place stops at round numbers or just below support levels and try to trigger these stops, the Market Makers are unlikely to do this. And small share trades are much more likely to be low/no commission buyers, such as those with a Freetrade account, rather than secret codes between Market Makers.
Many long-only investors don’t like that a stock they own could be lent out to those who may want to short it. If they hold a widely-shorted stock, they may even want to force the recall of lent stock to squeeze short-sellers and see the value of their investment rise. One myth that regularly does the rounds is that this can be achieved by putting in a limit sell order significantly higher than the current price.
The Truth: The FCA’s rules in this area say: “A firm must not undertake or otherwise engage in stock lending activity with or for a customer unless ... the firm has obtained the consent of the customer;” If investors have not given permission for their broker to lend stock they will not be doing so. All the major UK brokers, such as Interactive Investor, Hargreaves Lansdown and AJ Bell, say they do not lend out customers’ shares. Putting any type of order doesn’t change this. By doing this, investors are wasting their time. Even worse, they risk selling out of a winning stock on unexpected good news.
On any timeframe, stock market returns are “fat-tailed”; they exhibit large moves that exceed what would be predicted by a normal distribution. This means that there are a few days which make a massive difference to overall index returns, as this chart from Blue Square Wealth shows:
The Truth: It is technically accurate that missing just the ten worst days in the stock market would see investors generate much higher returns. The myth is that this is possible to do this consistently. The problem is that the best and worst days are clustered together. As Hartford Funds point out:
Avoiding the market’s downs may mean missing out on the ups as well. 78% of the stock market’s best days occur during a bear market or during the first two months of a bull market. If you missed the market’s 10 best days over the past 30 years, your returns would have been cut in half. And missing the best 30 days would have reduced your returns by an astonishing 83%.
As well as the way humans build knowledge leaving us open to believing stock market myths, there are a few specific biases which mean they are particularly susceptible to these misunderstandings:
Attribution bias (also known as self-serving bias) means the tendency to attribute successes to internal factors (such as skill or intelligence) and failures to external factors (such as bad luck or market manipulation.) This bias is behind many of the theories of Market Maker manipulation – the desire to blame poor investment decisions on the actions of others rather than owning mistakes.
Attribution bias is an integral part of ego protection. People who believed they would regularly make terrible decisions would never get out of bed and do anything constructive. However, when applied to investment decisions, blaming others is a recipe for disaster. It short-circuits the learning process and prevents investors from improving their process. Not accepting and learning from mistakes is a recipe for poor long-term results.
Unfortunately, investors are more likely to engage in ego protection when feeling insecure or threatened, such as after a significant investment loss. This is why many investors ignore the warnings in well-researched short reports and instead start believing in conspiracy theories.
The illusion of control is the tendency for people to overestimate their ability to control events. Investors placing out-of-the-money sell orders for their stock do so because they feel it gives them some control over whether others will take a contrary opinion on that stock. In reality, this is illusory.
Hindsight bias is the tendency for people who know the outcome of an event to perceive that it was more predictable than it was at the time. With hindsight, investors believe they could have timed the market and got out before the largest daily losses were incurred, improving their investment returns. But, of course, those same investors would need to have returned to the market shortly after those one-day losses to benefit from subsequent significant one-day gains.
When assessing any belief about the stock market, investors should consider whether these biases are at play. And above all, ask, ‘What is the evidence for believing this?’
About Mark Simpson
Value Investor
Author of Excellent Investing: How to Build a Winning Portfolio. A practical guide for investors who are looking to elevate their investment performance to the next level. Learn how to play to your strengths, overcome your weaknesses and build an optimal portfolio.
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Great article. I do think that Myth3 actually does happen on occasion but probably very infrequently.
Also still belive that 1 dog year equals 7 human years :)
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Oh no! Some of my favourite myths debunked!