Fifteen favourite fallacies

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13. "It can't possibly go any higher"

The next time someone offers you this opinion, ask why not. You will usually be palmed off with some such cliché as "What goes up must come down", or "No tree grows to the sky."

Actually, neither of these sentiments is quite as unscientific as it appears. "What goes up must come down" refers to the effect of gravity on, say, a flying cannonball. The equivalent in investment is the statistical phenomenon known as "reversion to the mean". A more accurate way of putting it might be: "Values that get way out of line with the average tend to revert to the average eventually."

But note that the key word is values, not prices. It is certainly not scientific to suppose that, just because a share price has gone from £1 to £20, it cannot go to £30 or £50. If the earnings continue to justify the share price, there is every reason to expect it to go higher. Coca-Cola stock was higher in 1998 than at any time in history. At that point, a share worth $100 in 1892 had grown to a value of $8.5 billion!

A more reasonable cause for worry is when the P/E ratio gets way ahead of the earnings growth. In that case, unless earnings pick up smartly, you will very probably see a nasty demonstration of reversion to the mean. If earnings rise 20%, but the P/E drops from 40 to 20, you will have lost 40% of your investment.

"But," you may object, "isn't there a limit to how high values can go?" Good question. There are sound, physical reasons why no tree grows to the sky. Trees are prevented from growing above a certain height by the force of gravity, which tends to cause a phenomenon known as "column failure" in trunks higher than 300 feet. Likewise, if it were possible for a big company to grow at 20-30% indefinitely, it would soon dwarf even the largest economies in the world.

But there is nothing to prevent companies growing at 20% for 20 years in a row. That is just what pest control specialist Rentokil Initial did. In the process, it multiplied investors money over 325 times. Yet how many of them missed out on the best part of that rise because they took some friend's or broker's silly advice to "sell when the price doubles"?

Don't sell gems for peanuts. It's always easy to be impressed by the high peanut-gem exchange rate, but in the end you're just short-changing yourself.

1. "Investing is just gambling anyway, so why not take a few chances?" 2. "You've got to speculate to accumulate" 3. "Growth always wins in the end/Value always wins in the end" 4. "Blue chips are best/Smaller companies are best" 5. "Penny shares are the best value for money" 6. "It's such a great company, I can't go wrong" 7. "But just look at the dividends" 8. "I've got to be in technology/biotechnology/telecoms etc" 9. "I missed that one, I'll catch the next one" 10. "Paper losses aren't real" 11. "I'll never go broke taking a profit" 12. "It can't possibly go any lower" 13. "It can't possibly go any higher" 14. I can't sell because of the tax bill 15. "This time it's different" 16. Conclusion

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