Dispelling Six Investment Myths

In the market, it's all about what you don't do, rather than what you do. So I'd like to dispel a handful of investment myths, in the hope that it will help you avoid some of what doesn't work in the stock market—and thus improve your returns. 

1. Insider selling isn't a major factor in a stock's future performance.

While most investors believe insiders are these all-knowing beings that will never sell their stock if something good was going to happen, history shows that's just not the case. Almost all of the biggest stock market winners experienced plenty of insider selling on the way up. Why? Usually it's because these winners were entrepreneurial companies, and the top brass was paid in stock (ownership), not cash. So, naturally, they cash in somewhat on the way up.

Insider buying might be slightly more meaningful (you only buy for one reason, but there are many reasons you might sell), but even then, insiders can buy well ahead of any rally in the stock. What really matters is the perception of institutional investors, e.g., hedge funds, mutual funds, pension funds and the like, that control trillions of dollars. If a few insiders want to sell $10 million of stock, but Fidelity Contrafund (or any one of a dozen other mega-sized funds) wants to buy $50 million, those insider sales won't mean a thing.

2. P/E ratios (for growth stocks) are a result of performance, not a cause of it.

Nearly everyone is raised in life to get a bargain, whether it's for a suit, a car or even for groceries. So when the average Joe sees a stock trading at 100 times earnings, he avoids it like the plague. But in reality, P/E ratios don't have a convincing correlation to growth-stock performance; sometimes a big winner will start off with a low P/E, sometimes it starts off with an average P/E, and sometimes it's high.  

What really counts isn't the P/E, but the firm's sales and earnings growth, its margins, its industry trends and its stock's performance, which tells you what institutional investors perceive. Those factors have a much higher correlation to future performance than P/Es do.

3. You CAN go broke taking a profit.

I recognize that there is no one best system for investing in stocks. Here at Cabot, we have analysts who are heavy on fundamentals (Cabot Small-Cap Confidential), value-based (Cabot Benjamin Graham Value Investor), momentum-based (Cabot Top Ten Trader) and so on. In the world of growth stocks, which I focus on, the key is to cut losses short while giving your successful stocks a chance to become big winners.

Sure, I'm all for lightening up on your winners from time to time, ringing the cash register and putting some money in your pocket. If nothing else, selling small amounts on the way up puts you in a positive state of mind, which is crucial for successful investing. But for most of your shares, you should be holding on and giving your top performers a chance to become big winners.  

Most investors regularly book three- or four-point profits, not realizing that they're also going to suffer many three- or four-point losses along the way (assuming they're smart enough to cut losses short). The result is so-so performance. And if they hit a losing streak, or let one bad stock get away from them, look out below.

4. Don't draw a major conclusion from just one or two events.

Ask yourself: If you sat down at a Blackjack table and were dealt a 19, what would you do? Stay, of course; the only cards that could help you would be an Ace (worth 1), or a 2, while everything else would bust you (result in something over 21).  

But after you stay, let's assume the dealer flips his cards ... and he has 20! You lose the bet. Now ... does that mean, next time in the same situation, you should hit on 19, instead of stay? No! And the reason is easy to understand: the odds favor you winning more often if you stay than if you hit. So you're not going to change your approach based on just one instance of losing.

Yet that's exactly what many investors do. They might sell a stock when they have a 15% loss (correctly cutting the loss short, and preventing potentially serious damage), but then that stock turns around and rallies. They conclude selling was the wrong thing to do. Big mistake!

What possibly went wrong was that the investor bought too high in the first place ... or, maybe, he just has to tip his hat to the market.  The point is that you want to have a sound process and set of rules to guide you through the investment battlefield. Don't overemphasize any one trade, good or bad; think of it as just the first of hundreds of trades you're going to make in the months and years ahead.

5. Diversification provides downside protection, but concentration allows for outperformance.

Listen to any "prudent" financial advice, and your best bet is to diversify—own 70% stocks, 25% bonds, 5% cash, or something of the sort. And, for most people, I believe this is good advice; over the longer-term, spreading out your bets in this way will lessen the chance you take any serious hits on the way to retirement.

But if you're investing to make money in growth stocks, it's all about concentration. In the Cabot Market Letter's Model Portfolio, we own a maximum of 12 stocks when fully invested. Personally, I tend to gravitate toward seven or eight. The key is to cut ALL losses very short, and average up on your best one or two winners. That way, you can make big money when the market is heading up. Diversification isn't wrong, per se, but neither is concentration reckless. Most of history's most successful investors concentrated in a few top stocks, as opposed to diversifying into 30 or 40 issues.

6. Worry first and foremost about making a profit. Taxes should be a very distant secondary consideration.

I literally just answered a phone call this week from a long-time, and very good, subscriber. He owned a stock that's being bought out, and his question was whether he should sell it. My answer was simple: Yes! Take the money and run. He had ample profits ... but he was hesitant to sell because it meant he would have to pay the taxes.

I understand where this thinking comes from, of course; I hate paying Uncle Sam every April as much as anyone. But your goal is to develop winners and make money, and paying taxes is the (unfortunate) reality of making money.

The key is to consider taxes before you buy a stock. For instance, if you have to pay 30% of any gains to Uncle Sam, you might consider investing somewhat more initially (in terms of dollars) since, if you win, you have to pay Uncle Sam his share. And if you lose, you'll be able to deduct it from your profits (if you have any). Even if you don't have profits in a given year, you might figure that, in the long run, you're going to make money, so any losses this year will eventually offset something in the years ahead.

Now, I'm not a tax attorney, so don't go taking my words of advice to heart. It's just something to consider. The main point is that your goal is to make money by following a sound system of rules and tools—don't allow tax considerations to cause you to make the wrong investment action.

These are just six of many common misconceptions investors have about the market. I don't mean that in a  "aren't they silly for thinking like that!" sort of way. Just the opposite, in fact—the market, as we like to say (and write), does its best to fool the majority, and take your money away. It's difficult to live a normal life, thinking one way, and then think totally differently when it comes to investments.

Hopefully, this information will help you think differently about the market, and help you avoid many of the mistakes that investors—both novice and experienced—continue to make today.

Click here for more information on Cabot Market Letter or Cabot Top Ten Trader.

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