Starting out as a young investor in stocks, I thought I had done a fair amount of reading and research before initially investing, but even a year or two into it, headlines and comments from friends or family used to confuse me when it came to stock market investing. To help you avoid some of the same confusion, I wanted to share three major misconceptions I’ve come across regarding stocks over the years:
- Stock Splits – When a company’s stock becomes very expensive (often over $100 per share), the management will often announce a stock split. What I used to hear now and then was that it’s a great time to buy just before the stock split since the share price normally runs up as investors are able to buy more shares at a cheaper price. As it turns out, that is completely untrue. See, stock splits are announced in advance, often many weeks in advance. What happens is the shares may get a little boost when the announcement itself occurs but not during the day of the split. The market is already well aware of the impending split and any runup would have already occurred as a result of the efficient market. So, the lesson here is NOT to buy a stock just because a stock split was announced.
- Cheap vs. Expensive Stocks – Another common stock myth is that stocks with low share prices are “cheap.” All that means is that the current share price might have a low value like $3 per share, but that doesn’t mean that it’s cheap on a “valuation” basis. You could have a stock that was $2 yesterday but $3 today and is now actually “overvalued.” It just happens to have a low share price. Investors should not consider what the current share price is in their calculations at all, but rather other more important fundamental factors like the actual value of the entire company, earnings, dividends and other factors that actually matter.
- Past Performance – Many stockpicking websites and magazines will often highlight the best stocks of the prior year or some period. Some of the continued strong performance is because of just these lists! People keep reading about a great performer from last year and buy it when they read about it in hopes of further share price increases. But eventually, the free market takes over and the share prices come back to earth if there are no underlying reasons for the strong share performance. Past performance is no guarantee of future results! Again, focus more on company fundamentals and not just past performance.
If you discount these three topics completely from your assessment of whether a stock is worth investing in, you’ll be better off!