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Stock market investment traps, tricks and myths.

July 27th, 2009 · Greg Atkinson · 2 Comments

The one sure thing about a bear market is that it provides fertile ground for the rise of investment myths and for people talking up certain assets classes by feeding on the fear of investors. But before you leap into some new investment it is probably a good idea to be aware of some of the common shares related investment traps, tricks and myths that exist.

Annualised Returns

If you invested say a $1000 in a stock then sold that stock one month later for $1100 you would probably say you made a gross return of 10%, but some investment newsletters and stock tippers see things differently. They use annualised returns and would say that the annualised return was actually 120%. (i.e. 10% return for one month x 12)

One reason they may do this is because they often promote small company stocks or push aggressive stock trading strategies and thus by annualising returns they can publish results showing a bagful of stocks they suggested with high “annualised” returns. Funnily enough I seldom see too many people highlighting annualised losses.

Annualising returns makes absolutely no sense to me and in my opinion is simply a way to dress up the performance of a stocks tip or portfolio. It also shows that many people in the investment community seem to struggle with basic maths.

I would suggest investors be wary of anyone that promotes annualised returns because in my opinion the only figure that counts is the one calculated using the money that actually went into your pocket.

Pump and Dump

This is where stocks with low stocks prices are talked up in the hope that a rush of investors will buy into the company and thus push the share price up by a large amount in percentage terms. This can also happen of course with blue chip stocks, but normally I find it is the smaller sized companies that are targeted most often.

It is true that the potential returns from investing in a stock trading at 1 cent can be fantastic if it rises to say 4 cents, but it is also quite possible the stock may never get above the price you paid or worse still the company goes under and you lose everything.

There are probably many hidden bargains amongst the many hundreds of ASX listed stocks and there is nothing wrong with looking for these. But investors just need to be cautious when following red hot stocks tips especially when the tipping party does not disclose the interest they have in the stock they are recommending.

Seeking high returns to cover losses

More often than not most of us suffer some losses in a bear market and so we are tempted by the idea of making some spectacular gains so that we can recover these losses. As a result we can be tempted by stocks that appear to offer the potential for the biggest capital gain and in doing so we may not appreciate the risks involved by following this sort of investment strategy.

There is a saying about investing in stocks which is “up by the stairs, down by the elevator” and this simply means that it usually takes time to build up gains in a portfolio, but these can quickly be erased when a correction comes around. Sometimes stocks can bounce back from a bear market rapidly but often it takes more than a year and even then some shares may never recover.

It is painful to take losses when the stock market falls but you can make things a lot worse by trying to make up ground too quickly by buying risky stocks or buying into a so called “hot” investment areas that turn out going nowhere.

It is better to switch to cash than ride out a stock market correction

It would seem logical that the best place for your money during a stock market correction would be in a nice safe bank account earning interest, but is that really true?

Firstly to really take advantage of a switch to cash you would need to get the timing right and the chances are that you will sell stocks below their peaks by some amount. (either before the correction or after you feel a correction is under way) Even if your timing was great I would suggest that it would be an excellent effort to sell out of stocks at say 5% below their bull market highs.

But after you have sold out of stocks you need to deal with tax and yet amazingly when many self anointed market experts talk about investing strategies they neglect to mention taxes. If you have held your stocks for more than a year then as things stand now you are entitled to a 50% reduction in capital gains tax (CGT) but you still need incur a tax liability. (but please check with a tax professional as regulations change)

Even if assume that you managed to pay just 10% CGT because your accountant was very clever (and you were not a high income earner) you would still have lost now 15% of your portfolios bull market peak value during the shift out of stocks. There will also be transaction costs such as broker fees but I will ignore there to keep things simple.

But then the question is will you stay in cash forever of move back into stocks and if so, when? If you got the timing just right then in theory you could buy back into stocks right at the bottom and ride the next bull market..in that case you would be an investment legend. But the reality is that very few people can get the timing right and investing greats like Warren Buffet, Jim Rogers or George Soros all say that timing the market is nearly impossible.

So in reality most investors will sell out of stocks well below their highs and miss the market bottom by a long way. Therefore if you really sit down and crunch the numbers and take into account tax, fully franked dividends, transaction costs etc. then you may find that moving into cash was certainly a safe move but may not pay off quite as well as you expected.

Residential property does better than stocks over the longer term (or vice versa)

I dislike making comparisons between investing and stocks and investing in residential property because they are vastly different forms of investment.

Normally when comparisons are made just a graph of property prices versus the ASX Index is shown and this fails to take into account dividends, rental income and tax implications for example. It also assumes that somehow you invested in a property (or properties) that moved exactly inline with the movement in average home prices in Australia and if you invested in stocks it assumes your portfolio tracked the movement of the ASX.

The fact is both investments can provide good returns to investors and may outperform each other during certain time frames. In addition properties in some location may generally underperform stocks where others areas property may generally outperform the stock market.

My point is that simple comparisons between stock and property returns are almost meaningless and investors should remember that graphs that show past returns are merely a record of what has happened, and not an indicator of how investments will perform in the years ahead.

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If anyone has some further stock market investment traps, tricks and myths then please let me know so I can add them to this list.


2 responses so far ↓

  • 1 AustralianStock guy // Jul 29, 2009 at 1:34 pm

    hi

    i would like to a do a link exchange with you. I have a similar blog to you and would

    appreciate if we can swap links to the benefit of us both.

    My Link is http://Www.australianStockwatch.com and Linking word is Australian Stocks.

    Please let me know or then put up my link at your website and send me an email to put up your link.

    Thanks a lot
    Jeff

  • 2 Greg Atkinson // Jul 29, 2009 at 5:41 pm

    Hi Jeff, we are starting to run out of space to put links onto this site but feel free to leave comments and your url will be linked from here anyway.

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