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4 Stock Market 'Truths' That Are Dangerously Wrong

Tuesday, November 6, 2012 - 11:30am

Scoring profits in the stock market isn't just about finding winning investments. It's also about avoiding the little landmines that tend to explode on those gains. And sadly, there are many hurdles that you need to be aware of as you make your investment choices.

Some of these investors' wounds can be self-inflicted. For example, a lot of investors buy stocks when the market has been steadily rising, and they sell their stocks after themarket has had a bad stretch. Yet Warren Buffett and others suggest the opposite tack: Sell stocks when the markets are surging, and load up on them when most others are fleeing.

From hidden costs to specious marketing pitches to an unawareness of the basics of cyclical investing, there are other ways in which investors unwittingly sabotage their own long-term performance. Here are four widely held beliefs about investing -- all of them wrong -- and how you can avoid them.

Myth: Wall Street's "Buy" List Is A Great Buy
Investors who use a full-service broker will occasionally be told of a "can't-miss idea that our analysts really like." Don't you believe it. Many brokers are handed a list of stocks by their managers to unload on clients. These are often stocks that are owned by the brokerage firm -- in large quantities -- and when these firms decide they don't want to hold that stock anymore, they try to pawn them off on unwitting investors. In this case, one's man junk is not another man's treasure.

You can usually spot these unwanted stocks by checking how long they have been slapped with a "Buy" rating. These ratings often get quite stale, and analysts infrequently update their ratings on particular stocks. So it's wise to ask when that analyst started recommending that stock. In fact, these firms are required to show a chart in every report revealing a history of ratings changes. If the analyst boosted the stock up to a "Buy" only recently, at least you can be assured that you're not the last one to get this "hot tip."

Myth: ETFs Are Always Low-Cost
In recent years, investors have been switching from mutual funds to lower-cost exchange-traded funds (ETFs). These alternative investments aren't run by high-priced fund managers and can charge lower expense ratios. But they're not as cheap as you think. A typical ETF has an expense ratio of around 0.5% or 0.6% (which means that they cost $50 for a $10,000 order).

Yet a number of ETFs have expense ratios that approach 0.8% or 0.9%. And that can spell trouble for anyone owning an ETF for just a few months. Considering that the average stock or fund rises about 5% to 8% per year on average, that works out to be less than 2% per quarter. And if you hold an ETF with a higher-than-average expense ratio for just three to four months, you've already spent a big chunk of your potential profits on these onerous fees.

Also, many ETFs (especially those that trade less than 10,000 shares per day) can have a wide spread between the bid (sell price) and ask (buy price). If the spread is 4 cents and you buy 2,000 shares, you've just lost another $8 just to get in and out of that ETF -- on top of the expense ratio fees.

Your best move: Buy ETFs that trade more than 100,000 shares a day (as they have narrow trading spreads) and carry expense ratios below 0.5%.

Myth: A Strong Economy Is A Great Time To Become An Aggressive Investor
Many investors forget the axiom: "The market always looks ahead." It may seem counterintuitive, but the biggest market gains can come when an economy looks weak. Savvy investors know a stock will rise or fall on the basis of future expectations. For example, the U.S. economy looked quite robust in 2007, yet by then the S&P 500 had just posted a five-year 90% gain. Signs of economic problems were just emerging, which eventually led the S&P 500 to plunge sharply by early 2009. Conversely, the economywas quite weak in early 2009, yet that turned out to be a great time to buy stocks, as the stage was set for the economy to eventually stabilize.

Fast forward to late 2012. The economy is on uncertain footing, and this may appear to be a risky time to invest. Yet a deep look at economic cycles has led forecasters to conclude that the economy -- led by a housing recovery -- may look a lot perkier by the middle of the decade. That helps explain why the S&P 500 has risen more than 10% in 2012 -- in anticipation of better days ahead.

Myth: Rising Interest Rates Are Bad For Stocks
In the 1970s, inflation rates were so high that it made little sense to own stocks. After all, fixed income investments such as bonds offered such high yields that you could do quite well without taking on the risk stocks bring. In the 1980s and 1990s, inflation (and interest rates) embarked on a long decline, which helped propel a bull market for stocks that lasted nearly 20 years.

As a result, investors have come to reflexively assume that when interest rates start to finally move up from their generational lows, it will be time to sell stocks. That's not necessarily the case. In fact, a moderate rise in interest rates isn't a reflection of inflationary pressures in the economy but simply a signal that the economy is getting healthier and bank funds are in greater demand.

The prime interest rate (which is typically around 3 percentage points higher than the federal funds rate set by the Federal Reserve) is 3.25%. This prime rate forms the basis of many consumer and business loan rates, from car loans to credit cards to mortgages. History has shown that the prime rate can rise to 5% or even 6% without choking off economic activity. And a move toward that figure could signal a firming economy, which is often a solid backdrop for stocks.

Action to Take --> Get to know these issues in greater depth. They can help you save money when it comes to seeking the right investments and can help you understand the appropriate times to move more funds into the market and when to ease away.

This article originally appeared on InvestingAnswers.com:
4 Stock Market 'Truths' That Are Dangerously Wrong

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.