On your journey to financial independence, it is hard to find a better ally than the stock market. Universally acknowledged as one of the best ways to build wealth over long periods of time, stock market investing has never been more accessible to retail investors.
Today, anyone with a bank account, internet access and £25 to their name can open a low-cost brokerage account and start investing in stocks within minutes.
At the same time – and despite the stock market’s record popularity, the volume of misinformation and fiction about stock market investing also seems to be hitting an all-time high.
Some of it can be quite benign and even funny – but other popular misconceptions can do serious damage to your financial well-being.
Today, let’s debunk some of the most common and dangerous misconceptions about the stock market.
Misconception #1: The Stock Market Is Really Complicated
It’s not. Let’s deconstruct stock market investing for what it really is.
Stocks / shares are simply certificates that give you an ownership stake in a given company. That company could be your father’s construction business. Or it could be Microsoft or Procter & Gamble.
However, your father’s construction company is (likely) not publicly traded while Microsoft is. The stock market is where the shares of publicly listed companies like Microsoft are traded. In the past, buying shares would actually involve getting a physical piece of paper. These days, all of the trading is in electronic form.
When you buy a share in Microsoft, you become a partial owner of the company. You have a tiny stake – but that stake is in a massive company with billions of revenue.
You are now entitled to a proportionate share of Microsoft’s profits. Some of those profits can be paid out as dividends – and you are entitled to a share of those dividends also.
Over the long run, companies tend to grow their profits. Correspondingly, your share of those profits goes up. This increases the value of the shares you hold. And you keep collecting whatever dividends are paid out.
The combination of the increase in the value of your shares and dividends received is how you make money in the stock market:
Microsoft makes money – you make money
Yes, it’s that simple.
Misconception #2: Investing In The Stock Market Means Investing In A Single (Or A Few) Companies
I am genuinely surprised at how many times I hear this. Sure, you could put all of your life savings in Microsoft. I am sure there are more than a few people who did that – and have done very well.
However, smart investors don’t do that. You may end up with a Microsoft. You could also end up putting your entire nest egg in Enron. Or Lehman Brothers.
To avoid that unfortunate outcome, smart investors buy shares in low-cost, passive index tracker funds. These tracker funds typically perform in line with a broad-based index of companies, such as the S&P 500 (which includes the largest 500 US companies by market value).
When you buy a share in an index tracker, you buy a tiny ownership stake in every single company that constitutes the underlying index. So instead of owning a tiny portion of Microsoft, you end up owning a tiny portion of all the constituents of an index (S&P 500).
So while individual companies can and do go bankrupt, stock market indexes grow with time:
Misconception #3: Stock Market Investing Is Equivalent to Investing In An ISA/LISA/Pension/401(k)
Nope. Not even close.
ISAs, LISAs, Pensions and 401(k) plans are just investment vehicles (also known as “investment wrappers”). Think of them as virtual envelopes in which you can hold your investments. You can choose what goes in those envelopes.
It can be cash. It can be bonds. Or it can be shares.
If you put your stock market investments into one of the wrappers above, you will typically get some form of a boost (typically in the form of a tax break) from the government and your employer. Take a look at the pension example below:
Or, as is the the case with a LISA, the government will give you a 25% bonus on your contributions.
This ability to give your savings an investments an extra kick makes investment wrappers fantastic wealth-building tools. However, on a purely definitional basis, ISAs, LISAs and Pensions have nothing to do with the stock market.
Misconception #4: You Can Lose All Of Your Money
This could well be the case – but only if you invest in a single company stock (i.e. Enron).
However, if you invest in an index tracker, you actually become a partial owner of hundreds, if not thousands of companies. Barring an alien invasion or an all-out nuclear war, the probability of all of them going bankrupt is zero. And face it – come nuclear winter, the value of your stock market investments probably won’t matter too much to begin with.
In addition, the beauty of investing in an index tracker is that the companies that don’t perform well tend to decline in value and excluded from the index.
They are replaced by new, more successful companies. At that point in time, you cease to be their shareholder of the companies that got kicked out of the index and become a shareholder of the companies that have been admitted to it.
The fear of losing all of their money is one of the biggest barriers to people investing in the stock market. It is also absolutely misplaced.
Unless you do something stupid, losing money (and more importantly, NOT making money) in the stock market over long period of time is nearly impossible.
Probability of losing money? Zero. Making 15%+ annualized returns? 23%. I’ll take my chances
Misconception #5: You Can Get Rich Quickly
As dangerous as #4 above is, this is probably an even more dangerous misconception to have.
Sure, there are examples of people who do. There are also examples of people who win the lottery. Despite what they may tell you, skill has absolutely nothing to do with it.
Not only most people fail to get rich quickly in the stock market, they actually underperform a simple index tracker:
A big reason for the underperformance? Trying to time the market. Chasing winners. Buying in at the top. Selling at the bottom.
As I said above, the upside is that it is very hard to lose money in the stock market. The downside, of course, is that true wealth creation takes decades.
The only way you get there is by putting money in the stock market, month in – and month out, without giving any regard to the news, politics, price moves, your brother-in-law’s advice etc etc etc…
So learn to be patient. It will make you happier. And it will also make you rich.