The Five Most Common Market Myths - Essay Example

Market Myths [Pick the School Market Myths Introduction Investopedia (2002, pg claims that, "When fiascos like the Enronbankruptcy,auditing scandals and analysts' conflict of interest occur, investor confidence can beat an all-time low. Many investors are wonder whether or not investing in stocks is worth all the hassle. At the same time, however, it's important to keep a realistic view of the stock market. Regardless of the real problems, common myths about the stock market often arise." The purpose of this paper is to discuss these market myths in detail, starting with the five most common. The Five Most Common Market Myths Myth Number One is that some people equate investing in the stock market to gambling with their money. As a result of this fallacy, a significant number of individuals avoid the stock market. An understanding of the reasoning behind purchasing stocks needs to be well-known in order for an individual to understand how investing in them is different from gambling. It is important to remember that a share of stock represents partial ownership in a company, and it gives the person who owns the stock some of the profits that the company makes and allows that individual to share assets (Investopedia, 2008, pg. 1). "Too often, investors think of shares as simply a trading vehicle, and they forget that stock represents the ownership of a company. In the stock market, investors are constantly trying to assess the profit that will be left over for shareholders. This is why stock prices fluctuate. The outlook for business conditions is always changing, and so are the future earnings of a company" (Investopedia, 2008, pg. 1). It is a rather daunting task to determine the value of a company at any given point. The Random Walk Theory applies, and this theory states that "there are so many variables involved that the short-term price movements appear to be random (Investopedia, 2008, pg. 1). The present value of a company is determined by the money a company will make over the long-term (Columbia Journalism, 2000 and Biriyini, 2000) "In the short term a company can survive without profits because of the expectations of future earnings, but no company can fool investors forever - eventually a company's stock price can be expected toshow the true value of the firm" (Investopedia, 2008, pg. 1) Also according to the article by Investopedia (2008, pg. 2), "Gambling, on the contrary, is a zero-sum game. It merely takes money from a loser and gives it to a winner. No value is ever created. By investing, we increase the overall wealth of an economy. As companies compete, they increase productivity and develop products thatcan make our lives better. Don't confuse investing and creating wealth with gambling's zero-sum game." Myth Number Two is that the stock market is some type of fancy, executive club reserved for the wealthy and for brokers and that the average person cannot play, or at least cannot play very well. The fact is that brokers do not hold all of the secrets anymore. Thanks to advances in technology and the advent of the Internet, all of the forecasting a research tools that brokers use are available to the general public as well, and they are really easy to get at pretty much any retail store that sells books and electronics (Investopedia, 2008). "Actually, individuals have an advantage over institutional investors becauseindividuals can afford to be long-term oriented. The big money managers are under extreme pressure to get high returns every quarter. Their performance is often so scrutinized that they can't invest in opportunities that take some time to develop. Individuals have the ability to look beyond temporary downturns in favor of a long-term outlook" (Investopedia, 2008, pg. 3). The third market myth is that stocks that have risen high and fallen will rise again. This is not necessarily true. Investopedia (2008, pg. 3) offers the following example: "Suppose you are looking at two stocks: XYZ made an all time high last year around $50 but has since fallen to $10 per share. ABC is a smaller company but has recently gone from $5 to $10 per share. Which stock would you buy Believe it or not, all things being equal, a majority of investors choose the stock that has fallen from $50 because they believe that it will eventually make it back up to those levels again. Thinking this way is a cardinal sin in investing! Price is only one part of the investing equation (which is different from trading, whch uses technical analysis). The goal is to buy good companies at a reasonable price. Buying companies solely because their market price has fallen will get you nowhere. Make sure you don't confuse this practice with value investing, which is buying high-quality companies that areundervalued by the market." The fourth market myth is that all stocks that go up must come down again. Another excellent example is provided by Investopedia (2003, pg.3) . "The laws of physics do not apply in the stock market. There is no gravitational force that pulls stocks back to even. Over ten years ago, Berkshire Hathaway's stock price went from $6,000 to $10,000 per share in a little more than a year. Had you thought that this stock was going to return to its lower initial position, you would have missed out on the subsequent rise to $70,000 per share over the following six years." Finally, the fifth main market myth is that, just because someone has minute knowledge in the stock market, they should go ahead and invest since it is better than having no knowledge in the stock market. "Knowing something is generally better than nothing, but it is crucial in the stock market that individual investors have a clear understanding of what they are doing with their money. It's those investors who really do their homework that succeed. Don't fret, if you don't have the time to fully understand what to do with your money, then having an advisor is not a bad thing. The cost of investing in something that you do not fully understand far outweighs the cost of using an investment advisor" (Investopedia, 2008, pg. 4). Why Lunatic Theories are Wrong McArdle (2008) shares a number of reasons why she believes the more far-fetched market myths are incorrect. The first one she states is that the Iraq war did not cause the current financial crisis, although it is most likely contributing to inflation and making oil harder to come by. She makes no further comment on the issue. According to McArdle's article (2008, pg. 1) "Real factor scarcity does not create the kind of inflation that touches off asset price bubbles. Only inflation of the money and credit supplies, by giving speculators money to borrow and spend on their favorite asset, has the (arguable) power to create these financial manias. Nor does the government's borrowing create these bubbles. If anything, it mitigates them by soaking up excess capital from the markets and thus raising interest rates higher than they would otherwise be. Essentially, the government took money out of the housing market and used it to blow things up in Iraq. Bad for Iraq, but probably good for the financial markets." The second one states that this state was not caused by the Bush tax cuts. When the government has a budget deficit, it does not cause financial chaos. Tax cuts bring higher interest rates, even when they are given out in order to stimulate the economy (McArdle, 2008). "Moreover, there's a strong argument to be made that the Bush tax cuts actually exerted some downward pressure on house prices. That's because when the tax rates fell, the value of the mortgage interest tax deduction also fell. Some of the money that people got back in the form of lower taxes probably went to the housing market, but you have to net out the amount of money leaving the housing market as the tax deduction became less valuable" (McArdle, 2008, pg. 1) The third item states that this mess could not have been prevented even if the country were on the gold standard (Eisenhower, 2008). "There are a lot of hucksters out there writing books and newsletters telling people that a gold standard (or some other commodity currency) is the cure for all their worries. The way they tell it, "hard" currency is a sort of broad-spectrum economic snake-oil, the ginseng of the financial markets. Only adopt their plan, they beseech, and America will no longer be plagued by exchange rate fluctuations, government profligacy, trade deficits, inflation, speculative mania, financial panics, or indigestion. This is triple-distilled balderdash" (McArdle, 2008, pg. 2). There is nothing magical about gold or basing your currency on it. The same is true of any metal. In fact, America had trouble when it was based on the gold standard (Daily Record, 2004). "The international gold standard in the 1920s and 1930s was marked by speculative mania, catastrophic deflation, competitive devaluations, massive exchange rate and trade imbalances, and of course the worst economic contraction in living memory. The depth and duration of which, I must point out, many economists attribute to America's fierce determination to defend her currency" (McArdle, 2008, pg. 2). The fourth item presented is that the current crisis was not caused by the repeal of Glass-Steagal. According to McArdle (2008, pg. 3): A little history: Glass-Steagall was a major act of the mid-thirties, which set up the FDIC to insure and regulate banks, and split off commercial banking operations from investment banking. In 1980, the feds repealed one of the act's major provisions, Regulation Q, which had allowed the regulation of interest rates on banks. This is why you now get a competitive interest rate on your bank account instead of a free toaster when you open an account. In 1999 Gramm-Leach-Billey repealed the separation of investment banking and commercial banking, which is why JP Morgan has a big enough balance sheet to buy Bear without fear of failure. Neither of these provisions created securitization, which got going in the late 1970s and early 1980s (a decent history can be found here, or you could just read Liar's Poker again). They also didn't create the march into ever-more-exotic financial instruments in the late 1990s and of course, our current decade. McArdle also makes further claims in her story, such as that the current crisis was not caused by the collapse of Bretton Woods. "Commodity/pegged currencies have exchange rate problems too, notably worsening balance-of-trade problems when currencies within the fixed-rate system become over or undervalued. Like, say, having the Chinese propping up the dollar to keep their exports competitive" (McArdle, 2008, pg. 3). The economy can play a large role in market conditions. Finally, the sixth item states that the" long twilight of American economic might is not yet upon us. Recessions and declines such as those that have occurred in Japan, Argentina, and Britain are caused by problems with the structure of their economy and the fact that their resources are not being allocated properly. Argentina did not become an industrialized nation, declining firms had Britain under control" (Alba, 1996 and Ebony, 1997). "We could develop those sorts of problems, but as of now, America is admirably adept at moving capital and killing off our dead companies. We may have a nasty, nasty recession, but it's not yet time to brush up on your subsistence farming skills. Later, if I have the strength, I'll muster a defense of fractional reserve banking" (McArdle, 2008, pg. 3). Market Myths: The Failings of Conservative Economics Galbraith claims that "the market really does rule, you can't do anything about it, and you'd better not try. Also, as John F. Kennedy once remarked: 'The great enemy of the truth is very often not the lie--deliberate, contrived and dishonest--but the myth--persistent, persuasive and unrealistic.' This is especially true on Wall Street, where myths are usually packaged as in-depth research reports. The purpose, of course, is not to impart wisdom but to win business" (Galbraith, 2008, pg. 1) A lot of research on this topic does not correctly represent history. "Much of what passes for research is ignorant of history. In the spring of 2003, as the market was bottoming out, the myth du jour was that the market required capitulation before burying the bear. As with many myths, the logic behind the argument was compelling: Bull markets develop only after investors throw up their hands, sell the last of their stocks and vow to never again own anything riskier than a passbook savings account. That didn't happen in 2003. A market rebirth did" (Galbraith, 2008, pg. 2) Market Myths: People Before Profits According to Eisenhower's article (2008, pg. 1), "We're taught in Economics 101 that markets perform their miracles "without coercion or central direction by anyone. We're repeatedly told that there are two types of economies: market and planned. The "hidden hand" operates in one, a heavy hand in the other. One is a "free economy," the other is a command economy. One is the road to democracy, the other a road to serfdom." George Bush reiterated this concept during his presidential campaign, but the government only gets directly in the way of these types of things. "If government simply got out of the way and let the "hidden hand" perform its magic, then freedom and prosperity would ring. This logic permits privatization, deregulation and neoliberalism, all sold as "freedom movements" (Galbraith, 2008, pg. 2). Over 50% of Americans now own stock, which are twice as many that held stock in the 1980s. Along with this came a new perspective that has touched popular attitudes. "This is why it is important to debunk the big lie about markets and freedom." In 1982, the Chile's military junta and their leader Pinochet were praised by Milton Friedman and their support for a full free market economy (Eisenhower, 2008, pg. 1). According to Galbraith (2001, pg. 1) "For those who may not remember, in 1973 the CIA and a few U.S. multinational corporations helped General Pinochet launch a brutal coup against the democratically elected government of Salvador Allende, a socialist. Economic disciples of Friedman were brought in to conduct a "free market experiment" on Chile. The job of the junta was to repress any political and labor opposition to the experiment." Also according to Galbraith, "The experience of Chile serves to define what neoliberals really mean by freedom. It is limited to the freedom of capital to shape markets to maximize unequal exchange and corporate profits. This freedom inevitably comes at the expense of the majority of workers" (Galbraith, 2008, pg. 1). During the 1990s, businesses in the United States adopted a similar practice by dramatically decreasing their expenses in order to maximize their profits. Examples of the way that companies began to cut costs included "downsizing, restructuring, controlling inventories, using contract workers, ... outsourcing and adoption of productivity-enhancing new technology. Labor markets were consciously arranged to meet the expectations of Wall Street." (Eisenhower, 2008, pg. 1 and Pollin and Cockburn, 1991) The same concept applies to the free market. The old is being replaced with the new. "For example, the "old" industrial economy is downsized and globalized to prepare for the new "information economy." Such transitions, however, are not on automatic pilot. They require not only careful planning and preparation but also an enforcement mechanism to extract all the "magic" from markets" (Eisenhower, 2008, pg. 1). Twenty Myths About Markets Palmer (2007) says that, "When thinking about the merits and the limitations of solving problems of social coordination through market mechanisms, it's useful to clear away some common myths. By myths I mean those statements that simply pass for obviously true, without any need for argument or evidence. They're the kind of thing you hear on the radio, from friends, from politicians - they just seem to be in the air. They are repeated as if they're a kind of deeper wisdom. The danger is that, because they are so widespread, they are not subjected to critical examination" (Palmer, 2007) Here, he presents 20 myths for discussion. He divides the myths into four categories: ethical criticisms, economic criticisms, hybrid ethical-economic criticisms, and overly enthusiastic defenses (Palmer, 2007). The first category to start with would be ethical criticisms. One of these suggests that markets are immoral. "Markets make people think only about the calculation of advantage, pure and simple. There's no morality in market exchange, no commitment to what makes us distinct as humans: our ability to think not only about what's advantageous to us, but about what is right and what is wrong, what is moral and what is immoral" (Palmer, 2007, pg. 1). Next is the myth that markets promotes people to have greed and selfishness. "People in markets are just trying to find the lowest prices or make the highest profits. As such, they're motivated only by greed and selfishness, not by concern for others (Palmer, 2007, pg. 1). The second category covers economic criticisms. First up is the myth that monopoly can be caused by reliance on markets. "Without government intervention, reliance on free markets would lead to a few big firms selling everything. Markets naturally create monopolies, as marginal producers are squeezed out by firms that seek nothing but their own profits, whereas governments are motivated to seek the public interest and will act to restrain monopolies" (Palmer, 2007). The next myth is that markets depend on perfect information and that they require government regulation to make that information available. "For markets to be efficient, all market participants have to be fully informed of the costs of their actions. If some have more information than others, such asymmetries will lead to inefficient and unjust outcomes. Government has to intervene to provide the information that markets lack and to create outcomes that are both efficient and just" (Palmer, 2007). The fifth myth is that markets only work when an infinite number of people who have perfect information trade commodities that is undifferentiated. "Market efficiency, in which output is maximized and profits are minimized, requires that no one is a price setter, that is, that no buyer or seller, by entering or exiting the market, will affect the price. In a perfectly competitive market, no individual buyer or seller can have any impact on prices. Products are all homogenous and information about products and prices is costless. But real markets are not perfectly competitive, which is why government is required to step in and correct things" (Palmer, 2007). The sixth myth is that markets cannot produce public goods. Palmer (2007) says: If I eat an apple, you can't; consumption of an apple is purely rivalrous. If I show a movie and don't want other people to see it, I have to spend money to build walls to keep out non-payers. Some goods, those for which consumption is non-rival and exclusion is costly, cannot be produced on markets, as everyone has an incentive to wait for others to produce them. If you produce a unit, I can just consume it, so I have no incentive to produce it. The same goes for you. The publicness of such goods requires state provision, as the only means to provide them. Such goods include not only defense and provision of a legal system, but also education, transportation, health care, and many other such goods. Markets can never be relied on to produce such goods, because non-payers would free-ride off of those who pay, and since everyone would want to be a free-rider, nobody would pay. Thus, only government can produce such goods. The seventh myth tells readers that markets will not work, or will not be efficient, when externalities are negative or positive. "Markets only work when all of the effects of action are born by those who make the decisions. If people receive benefits without contributing to their production, markets will fail to produce the right amount. Similarly, if people receive "negative benefits," that is, if they are harmed and those costs are not taken into account in the decision to produce the goods, markets will benefit some at the expense of others, as the benefits of the action go to one set of parties and the costs are borne by another" (Palmer, 2007). The eighth myth states that the more complex and detailed a particular social order is, the more it needs government direction and the less it relies on markets. "Reliance on markets worked fine when society was less complicated, but with the tremendous growth of economic and social connections, government is necessary to direct and coordinate the actions of so many people" (Palmer, 2007). The ninth myth is that markets don't work in developing countries. "Markets work well in countries with well developed infrastructures and legal systems, but in their absence developing countries simply cannot afford recourse to markets. In such cases, state direction is necessary, at least until a highly developed infrastructure and legal system is developed that could allow room for markets to function" (Palmer, 2007) The 10th myth is that markets can lead to disastrous economic cycles. "Reliance on market forces leads to cycles of "boom and bust," as investor overconfidence feeds on itself, leading to massive booms in investment that are inevitably followed by contractions of production, unemployment, and a generally worsening economic condition" (Palmer, 2007). The 11th myth is that too much reliance on markets is silly, just like similar actions in the economy are. Most people understand that it's unwise to put all your eggs in one basket. Prudent investors diversify their portfolios and it's just as reasonable to have a diversified "policy portfolio," as well, meaning a mix of socialism and markets" (Palmer, 2007). The 12th myth is that markets lead to more inequality in general than non-markets end up leading to by default. "By definition, markets reward ability to satisfy consumer preferences and as abilities differ, so incomes will differ. Moreover, by definition, socialism is a state of equality, so every step toward socialism is a step toward equality" (Palmer, 2007). The 13th myth is that markets cannot meet human needs, such as the basics that appear on the bottom of Maslow's Hierarchy of Needs. "Food Goods should be distributed according to principles appropriate to their nature. Markets distribute goods according to ability to pay, but health, housing, education, food, and other basic human needs, precisely because they are needs, should be distributed according to need, not ability to pay" (Palmer, 2007). The 14th myth is that markets rely on the survival of the fittest. "Just like the law of the jungle, red in tooth and claw, the law of the market means survival of the fittest. Those who cannot produce to market standards fall by the wayside and are trampled underfoot" (Palmer, 2007). Myth # 15 states that markets debase culture and art. "Art and culture are responses to the higher elements of the human soul and, as such, cannot be bought and sold like tomatoes or shirt buttons. Leaving art to the market is like leaving religion to the market, a betrayal of the inherent dignity of art, as of religion. Moreover, as art and culture are opened more and more to competition on international markets, the result is their debasement, as traditional forms are abandoned in the pursuit of the almighty dollar or euro" (Jordan, 2007). The 16th myth is that markets are only for the rich or talented. "The rich get richer and the poor get poorer. If you want to make a lot of money, you have to start out with a lot. In the race of the market for profits, those who start out ahead reach the finish line first" (Jordan, 2007). Myth #17 is that prices go up when they are liberalized and subject to market forces. "The fact is that when prices are left to market forces, without government controls, they just go up, meaning that people can afford less and less. Free-market pricing is just another name for high prices" (Jordan, 2007). The 18th myth states that privatization and marketization in post-communist societies were corrupt, which shows markets are corrupting. "Privatization campaigns are almost always rigged. It's a game that just awards the best state assets to the most ruthless and corrupt opportunists. The whole game of privatization and marketization is dirty and represents nothing more than theft from the people" (Jordan, 2007). The 19th myth says that all relations among humans can be reduced to market relations and absolutely nothing else, which is kind of scary. "All actions are taken because the actors are maximizing their own utility. Even helping other people is getting a benefit for yourself, or you wouldn't do it. Friendship and love represent exchanges of services for mutual benefit, no less than exchanges involving sacks of potatoes. Moreover, all forms of human interaction can be understood in terms of markets, including politics, in which votes are exchanged for promises of benefits, and even crime, in which criminals and victims exchange, in the well known example, "your money or your life" (Jordan, 2007). The 20th myth states that markets can solve all of their problems without any government assistance. "Government is so incompetent that it can't do anything right. The main lesson of the market is that we should always weaken government, because government is simply the opposite of the market. The less government you have, the more market you have (Palmer 2007). Five Other Common Myths DiLiddo has another take on the five most common stock market myths. According to him, "To a large degree, the investment community is their own worst enemy in scaring off the individual investor. This is very unfortunate because stock investing is one of the best avenues the average person has of accumulating substantial wealth" (DiLiddo, 2008). The myths he shares are as follows: MYTH #1: PRICE TO EARNINGS RATIOS TELL YOU WHETHER STOCKS ARE CHEAP OR EXPENSIVE. MYTH #2: YOU MUST ASSUME HIGH RISKS TO MAKE GOOD MONEY IN THE STOCK MARKET. MYTH #3: BUY STOCKS ON THE WAY DOWN AND SELL ON THE WAY UP. MYTH #4: STOCKS ARE A HEDGE AGAINST INFLATION MYTH #5: YOUNG PEOPLE CAN AFFORD TO TAKE HIGH RISK (DiLaddo, 2008) He also offers the following handy advice for making good money in stocks at low risk: Buy stocks with consistent, predictable earnings growth Buy stocks with earnings growth rates of at least equal to the sum of current inflation and interest rates. Do Not put more than 10% of your money into any single stock Do Not own more than two stocks in the same industry. Do Not plunge into the market. Spread the investments over time. Use Stop-Sell orders to limit risk (DiLaddo, 2008) Another Take on Market Myths Investopedia also offers its take on stock market myths. They will be explained in detail in the following paragraphs. The first myth that Investopedia presents is that the stock market is a form of gambling. The second myth that they present is that successful investing can only be done with proper stock market predictions. Myth number three states that people believe stock prices that go up have to naturally come back down again. Myth number for is the direct opposite: people believe that stock prices that go down have to naturally come back up again. These myths are slightly different than the ones that have been presented in other areas of the paper, but as you can see, there is a great deal of overlap (Investopedia, 2008). Conclusion The purpose of this paper has been to discuss several takes from different authors on market myths and describe them in detail, starting with the five most common and ending with a large list of 20 examples. Investor confidence can really suffer when big name companies end up in the media spotlight for scandals. This can place investor confidence at an all-time low. Is investing in stock worth it Hopefully after reading this paper, an individual will be able to dispel the common myths and answer with a 'yes.' As previously mentioned, however, it's important to keep a realistic view of the stock market. Myths arise right along with the truth. References Investopedia 2008, 'The 5 biggest stock market myths', Available at: http://www.investopedia.com/articles/02/061902.asp McArdle, M. 2008, 'Market myths', The Atlantic Monthly, [Online] Available at: http://meganmcardle.theatlantic.com/cgi-bin/mt/mt-tb.cgi/20128 Galbraith, J.K. 2001, 'Market myths: The failings of conservative economics', Washington Monthly, [Online] Available at: http://www.washingtonmonthly.com/features/2001/0103.galbraith.html Birinyi, L. 2007, 'Market myths', Forbes, [Online] Available at http://members.forbes.com/forbes/2007/0416/182.html Eisenhower, D. 'People before profits: Market myths. 2008 People's Weekly World Palmer, T.G. 2007 'Twenty myths about markets.' Cato Institute Buell, J. 1994, 'Market myths', The Humanist, Vol. 54 'Business briefing,' 2004 Daily Record (Glasgow, Scotland). Bierman, H., Jr. 1991 'The great myths of 1929 and the lessons to be learned', Greenwood Press. Davidson, W. and D.L. Worrell 1994 'ESOP's fables: The influence of employee stock ownership plans on corporate stock prices and subsequent operating performance', Human Resource Planning, Vol. 17 Chase, E. 1999 'Myths of rich and poor: Why we're better off than we think.' Challenge, Vol. 42 'Understanding the stock market.' 1997 Ebony, Vol. 52 Gray, J. 2003 'New science, old myth: From the middle ages through Marx to the free market, humankind has clung desperately to the idea of progress, and still we delude ourselves. New Statesman, Vol. 132 Frank, T. 2002 'Shocked, shocked! Enronian myths exposed' The Nation, Vol. 274 'Myths about trade,' 2000 Columbia Journalism Review, Vol. 39. Pollin, R and A. Cockburn 1991 'The world, the free market and the left; Capitalism and its specters. The Nation, Vol. 252. Cox, H.G. 1999 'Market as God: Living in the new dispensation.' The Atlantic Monthly, Vol. 283. Albo, G. 1996 'The world economy, market imperatives and alternatives. Monthly Review, Vol. 48. DiLiddo, D. 2008 'Stocks, strategies, and common sense.' http://www.vectorvest.com/research/marketmyths.htm Read More