When you’re trying to research an investment of any kind, you probably go straight to a historical price chart before anything else. There’s nothing wrong with that, except that most people have absolutely no idea how to read a stock chart correctly.
It seems like common sense: If the graph increases steadily over time, then the investment is producing a solid return. But sometimes, even simple conclusions like that one can be dead wrong. Here are the four most common mistakes to avoid when looking at charts for stocks, mutual funds, ETFs, and more.
1. Being Misled by Stock Charts that Ignore Distributions
Whether you use Google Finance, the Apple Stocks app, or something else, your stock market graphs probably look very similar to the one below.
Based on your own stock chart analysis, what return do you think an investor would have earned if they’d held Best Buy shares for the last 5 years (as of the chart date)?
At first, this seems like an easy question with an obvious answer: The return was +30.08% in 5 years. It’s right at the top of the chart!
But that’s actually very wrong. A 5-year investment in Best Buy ending on September 9, 2022, would have returned closer to +57% — nearly double what this Google stock chart says. The reason is because almost all stock charts completely ignore the existence of distributions (such as dividends).
In addition to increasing in price during this 5-year interval, Best Buy also paid a quarterly dividend to its shareholders along the way, resulting in a much higher return than what’s shown in this simple stock analysis.
Most stock charts report something called price return, which is just the percent increase in share price over a given timeframe (a pretty useless number on its own). A much more important metric is total return, which includes all distributions to shareholders and assumes that they get automatically reinvested into more shares along the way (something you can easily set up in any good brokerage account).
@tripofalifestyle One of the most common beginner investor mistakes. — #stocktok #investing #stocks #moneytok #stockmarket #💰 #📈 ♬ original sound – Trip Of A Lifestyle
You can figure out cumulative and annualized total returns for a stock, mutual fund, or ETF by using the calculators on DQYDJ.com, or on any other site where you specifically see the words “total return.” The “Trailing Returns” tab of any Morningstar quote is a quick and easy place to look for total returns, too. Maybe one day Google, Apple, and the rest will finally catch up. 😞
2. Forgetting the Effects of Inflation on Investments
Let’s try another example. Instead of reading a stock chart this time, we’ll take a look at the finance world’s favorite commodity — gold.
Analyze the graph below and try to answer this simple question: If an investor bought gold in September 1982, how many times more would it be worth in September 2022?
Again, this seems like it should be a pretty easy investment analysis. If we divide the final price ($1,718.03) by the initial price ($443.75), we find that gold is worth 3.87× as much at the end of this 40-year holding period. With a little more math, we can figure out that this equates to a cumulative return of +287%, or an annualized return of +3.4% (per year).
We certainly haven’t forgotten about any distributions, because hunks of metal don’t pay dividends. So, what’s the problem?
Well, gold truly did increase in dollar value by about 3.4% per year over this 40-year period, and its price really was 3.87× higher at the end. This is called the nominal return of the investment (“nominal” basically means “before accounting for inflation”), and it’s what you see reported almost everywhere.
But, the price of everything else measured in dollars also increased by about 2.8% per year on average (the inflation rate) in that same timeframe. Or, in other words, the dollar itself lost purchasing power.
By subtracting the annual inflation rate from the annual nominal return, we get the real return of our investment (“real” just means “after accounting for inflation”). This tells us how much more “stuff” the gold is capable of buying.
Over this period, the real return of gold was only around +0.6% annualized. In other words, after waiting 40 years, our investor can only buy about 1.3× as much “stuff” with their gold as when they started — much less than the 3.87× multiple we originally calculated. Gold hardly produced any real return at all!
If all this math confuses you, don’t sweat it. You can use online tools to figure out real returns for popular investments, like the DQYDJ S&P 500 Return Calculator, which offers inflation adjustment as an option when doing broad stock market analysis, or the handy Macrotrends chart for gold.
By the way, the real total return of the S&P 500 was about +8.75% annualized over the same 40-year period as the above gold chart, which would have multiplied an investor’s purchasing power 27.5× after accounting for inflation. As a general rule, stocks are much better long-term wealth builders than commodities.
3. Ascribing Meaning to Stock Chart Patterns
If an otherwise well-performing stock suddenly started trending downward in price every day for a week, what would your intuition be about its future trajectory?
Some would say that the stock has “downward momentum” and will continue to fall. Others would say that the stock is “on sale,” and it’s a good idea to buy it at a discount before it rebounds.
I would say that none of them has any idea what they’re talking about.
People who use something called “technical analysis” of stock charts to predict future price moves are known as “chartists.” Their tools have fancy names like “Bollinger bands,” “envelope channels,” and “bearish resistance lines,” but they have a poor track record of predicting anything reliably. That’s because these tools rely on visual elements of stock charts, without regard for a company’s fundamental value or real-world performance.
Chartists are basically the astrologists of the stock market. They see grand meaning in supposed stock chart patterns, when in reality, they’re usually just looking at random noise.
The human brain has a tendency to see order in chaos, but it’s not always right. If you’d like to learn why stock market technical analysis doesn’t work very well, I highly recommend picking up a copy of A Random Walk Down Wall Street by Princeton economist Burton Malkiel (and then just sticking your money in an index fund as he suggests).
4. Focusing Too Narrowly
To tell you the truth, I don’t even look at charts for individual stocks any more, because I don’t actually invest in individual stocks any more. My wife and I retired early on a simple portfolio of broad, low-cost index funds that track the performance of the entire stock and bond markets. Investing this way has allowed us to spend less time thinking about money and spend more time doing fun stuff with our investment returns.
Glancing at graphs to help you understand different investment options is fine, but don’t try to glean too much insight from narrowly-focused information.
Rather than comparing MSFT to AAPL, try comparing charts of ETFs and mutual funds that cover entire asset classes, like stocks, bonds, and real estate — and learn the differences in risk and return between them.
And rather than constantly looking at what the stock market has been doing over the last few days, months, or years, try reviewing its performance over multi-decade holding periods. You’ll eventually be convinced that a long-term, buy-and-hold strategy is the surest and simplest path to wealth.
My very best advice on how to read stock market charts is: Don’t look at them too often.
— Steven
