It takes a Wall Street villager to set investors straight about the stock market.
That’s why I recently interviewed Jeff Bierman, the former chief market technician at brokerage TD Ameritrade who now is a portfolio manager for a private family pension fund. Bierman highlighted seven misconceptions investors have about the stock market — some of which may be surprising and all of which are worth noting:
1. Dollar-cost averaging controls risk
Dollar-cost averaging, or easing into a stock position at various price levels in order to mitigate risk, can backfire, Bierman says — particularly if you are averaging into a losing position.
Says Bierman: “Let’s say I buy 200 shares of an oil stock at $50 per share. Then I buy 200 more shares at $45. Two months later I buy 200 more shares at $40. I now own 600 shares with an average price of $45, but the stock is at $40.”
He explains: “Here is what I have done: I have added more risk to a losing position. I have forced myself to be right and play the ‘get-even-itis” game. I’ve eaten up my buying power, I haven’t hedged off of my position, and I held on to stubbornly prove I am right. It can be a highly dicey strategy and advisors recommend it all the time.
“What can I do instead? Take the other side: If you buy a stock at $50 and it goes to $55, buy more. If the stock goes to $60, buy more. You’ve added some risk to a winning position. Dollar-cost averaging can be prudent in a winning position, but it’s often foolish in a losing position. Cut your losses if you have a losing position or hedge the position off to some degree. Don’t add risk and suffer more potential losses.”
2. Diversification protects your portfolio
“Most people think that a diversified portfolio will give them plunge protection,” Bierman says. “Wrong, wrong, wrong. If anything, you could lose more than you think.”
He adds: “Many people own stocks from different sectors and think they are diversified. However, most of those stocks are probably correlated to the S&P 500 SPX, -0.00% . That means if the S&P drops by 10%, your portfolio could likely drop by 10% or worse. One way you can be truly diversified is if you put hedges in place. That means buying put options against the portfolio or short index futures contracts. That’s diversification.” (Note: Put options are less risky for individual investors.)
3. Fundamentals drive stock prices
Fundamental factors play a part in stock price trends, but they are not the sole driver, Bierman says. “What drives stock prices nowadays,” he adds, “are mainly order flow and perception, not fundamentals.
“Fundamentals don’t necessarily mean as much until the market goes haywire. When the stock market tanks, people tend to defer to the P/E and dividend yield. That’s when the fundamentals come into focus, and that’s when investors tend to hold their positions or sell with impunity.”
4. Short-selling harms the market
Short sellers can sometimes make the market, Bierman says.
“Most trading nowadays is done by electronic algorithms,” he points out. “And these algos are constantly buying and selling. If the market gaps down, who do you think they have to depend on to buy? The short sellers. They might be the only ones who will buy in a falling market.”
Bierman adds: “If the market falls, you better pray there are short sellers. They provide liquidity. When the market tanks, if you don’t have artificial buyers like short sellers stepping in, you could have serious liquidity problems.”
5. The stock market mirrors the economy
In fact, Bierman notes, most of the time the stock market and the economy are “completely divorced” from each other.
“Often times the stock market rallies while the economy gets worse, and by the time the market breaks trend, the economy is already in recession,” Bierman says. “Most people will sell when the economy has already bottomed out and buy when the economy is peaking. What are people doing now as we are near all-time highs? They are buying. Many market historians write that the stock market is looking six months ahead. Surprise! The market can be behind the curve.”
“‘The next bear market could be devastating. People think that 2008 was the worst, but it might not be.’”
— Jeff Bierman
6. Wall Street stock analysts are ahead of the curve
“I used to be an equity analyst,” Bierman says. “And I can tell you from experience analysts are rarely ahead of the curve. Analysts tend to be reactive, not proactive. Here’s an example: A company releases earnings and they are great and the stock gaps up. So the analyst upgrades it after it goes up by $20 per share.
“That’s like having my house burn down and you telling me I should have bought a fire alarm,” Bierman says. “What good is it to me now? Many analysts will upgrade a stock after it’s gone higher and downgrade after it’s been destroyed. If they want to be helpful, they should make their call before the stock moves, not after.”
7. Market corrections are a thing of the past
The current U.S. bull market has been like a fairy tale, Bierman says. “Zero interest rates, no correction in four years, people buying on the dip, and investors chasing performance. And they’ve been rewarded for it.
“The next bear market could be devastating,” he says. “People think that 2008 was the worst, but it might not be. The next one could be far worse because we are at a far higher level with more leverage, and far more stressed valuations on momentum stocks, and far less liquidity to absorb downward shocks. Right now the bulls seem focused on the story behind the stock. They want the sizzle, but what about the steak? That’s when investors could get a horrific history lesson, which is like getting hit with a two-by-four rather than a wiffle bat. I think we’re in a high-level churning process where the path of least resistance is to the downside.”
Bierman’s parting advice: “Always think risk first, and reward second. If you are 30% correct in baseball, and bat .300, you are a superstar. In the stock market you will not be 100% right. You are going make a lot of mistakes. It’s the nature of the business. The most important thing to help you survive the market turbulence is risk management.”
