These Are 5 Things You Should NOT Do In The Stock Market
Charlie Munger, the long-time investing sidekick of Warren Buffett, has shared plenty of wisdom over the years on the markets and life in general.
One of my favourite Mungerisms is this: “Tell me where I’m going to die, that is, so I don’t go there.” This illustrates the importance of negative knowledge – the knowledge of what not to do. With that, here’s a list of “Don’ts” in investing that I’ve been using for years. It’s something that has been very helpful for me, so I would like to share it with other investors.
1. Don’t jump in and out of stocks.
Finance professors Brad Barber and Terry Odean once studied the six-year trading records (the period was for 1991 to 1996) of over 66,000 households in the US and published their findings in a paper titled “Trading Is Hazardous to Your Wealth”.
What they found was that in the six-year block, the investors who traded the most earned an average return of 11.4% per year. The market however, generated a return of 17.9% per year for the same period. What’s more, the average annual return for all the investors in the study was 16.4%. As you can see, trading is indeed hazardous to one’s wealth.
2. Don’t underestimate the power of time.
Financial advisor Nick Murray once said that “Timing the market is a fool’s game, whereas time in the market is your greatest natural advantage.” How true.
Barber and Odean’s study is a great example of how trying to time the market (by excessive trading) can be destructive for an investor’s returns. The chart below is a great illustration of how time in the market is an investor’s ally:
Source: S&P Global Market Intelligence; author’s calculations
The chart shows the odds of making losses in the Straits Times Index (SGX: ^STI) from 1 May 1992 to 12 January 2016 for different holding periods (dividends and inflation are not accounted for). And as you can see, the longer you hold your stocks, the lower your chances of making a loss. For the timeframe under study, a holding period of one year gives a 42% chance of suffering a loss. For a 20-year holding period however, the historical odds of making a loss are 0%.
There’s a similar dynamic as well in the US stock market. There was never a 20-year period between 1871 and 2012 (that’s more than 100 years of market history!) in which an investor who held the S&P 500 had lost money. The S&P 500, as some of you may know, is one of the most widely followed indexes for US stocks.
3. Don’t blindly invest in a company just because it looks cheap.
Commodities trader Noble Group Limited (SGX: CGP) was valued at just 0.31 times book value and 0.017 times trailing revenue a year ago. But, from then to today, its shares have declined by a massive 79% in price from a split-adjusted S$2.20 to S$0.46. This comes after the company’s book value per share had been chopped by 44% from US$5.20 to US$2.94 in the same period.
The lesson here is that a cheap valuation can’t give us much protection if a stock’s underlying business performance is poor.
4. Don’t overpay for a company’s shares.
If you had bought shares of local banking giant DBS Group Holdings Ltd (SG:X D05) at the company’s pre-financial-crisis peak of S$24.90 more than 10 years ago on 23 May 2007, you would still be down by 18% at today’s price of S$20.40.
During that time frame, the bank’s book value per share actually stepped up by 3.5% per year. Although the growth rate was slow, the bank had been building value for shareholders steadily over time. So what may have caused DBS Group’s dismal performance in the stock market? The answer is valuation. On 23 May 2007, the bank was valued at 1.94 times book value – that was an expensive price to pay.
In contrast, if you had bought DBS Group’s shares at the financial crisis low of S$6.45 on 9 March 2009, you would be up by 216% now. Back then, the bank’s price-to-book ratio was just 0.49.
5. Don’t fret about the economy.
It’s near-impossible to guess what the economy would do. And even if you could, there’s very little about the economy’s performance that can tell you what stocks would do next. The chart below shows how various US economic and financial indicators had fared when it comes to forecasting what US stocks would do over the next 10 years:
As you can see, even rainfall in the US can tell us more about the country’s future stock market returns than its GDP numbers, corporate profit margins, and bond yields.
Investing legend Peter Lynch once said that “If you spend more than 13 minutes analysing economic and market forecasts, you’ve wasted 10 minutes.” When it comes to the stock market, it’s best to study individual businesses and invest accordingly.