Ignore sharemarket cliches and your portfolio will thrive

Assumptions are the mother of all cock-ups, and here are five of them, with five more next week.

Assumptions are the mother of all cock-ups, and here are five of them, with five more next week.

Let's start with the basics.

Making money is about predicting share prices

Not really. Making money is about entering an investment (a stock) with as high a probability of getting the direction right as possible.

You can narrow the odds in a million ways but, ultimately, the best you can do is narrow the odds of getting it right rather than wrong. The game is about doing your best, not predicting the future. And when, a second after you invest, everything changes, you accept it. There's no "mistake", there's simply an outcome you have to deal with. If you narrow the odds, you will win more than lose, and that's about as good as it gets.

What goes up must come down

Definitely wrong. What goes up is more likely to keep going up and what goes down is more likely to keep going down. They say the best technical analysts are kids. Show a five-year-old a chart and ask them if the stock is going up or down and they will tell you the obvious truth, not concoct some miraculous pivot point out of nothing. The trend is more likely to be your friend.

What's more likely? That a stock that falls 10 per cent is going to miraculously turn and go up for ever more, or that there's something wrong and it's going to trend down?

Diversification is good

The argument for diversification is based on the mathematical truth that if you combine risky assets you reduce overall risk. But the reality is that you also reduce return. If you diversify, you are committing yourself to the average return and accepting average market fortunes.

Diversification negates the whole idea of the equity market, which is to take more risk to make better returns. You don't do that by avoiding risk. You do it by embracing it, controlling it and winning at it.

History repeats

This is one of the weakest tenets of financial research. If you add up the performance of the All Ordinaries index in every month of the year for the past 100 years, you will find there is one month that is statistically the best month of the year and one that is the worst.

But it is just a statistic, not a prediction. You were bound to come up with a good month and a bad month. Unless you can explain the reason a statistical phenomenon will repeat, it is of no value.

Who cares if the sharemarket goes up in an election year and down in October. What about this year? Some of the "Sun Spot"-type predictions are simply people with too much time and data on their hands.

Statistically, nine out of 10 statements that begin with the word "statistically" are utter rubbish.

Dividends are good

Not necessarily. Return on equity - the amount of money a company makes on the money you give them - is far more important than how much money they give you back.

Good companies should have a yield of zero because it is far better for shareholders to have them keep the money and invest it in the business than return it to you. Why invest the money in the first place if they're just going to give it back?

A high yield also suggests a mature, low-growth company with few growth options to invest in. The dividend decision can also be driven by a lot of factors that do not reflect success, such as the CEO having a lot of shares. Yes, income stocks are in favour in this rather unique income-deprived moment in investment history, but they won't be forever.

You need to look at the total return from an investment (capital plus income), not yield. The yield is a distraction from the share price, which is far more important and can do you far more damage than a dividend will do you good.

Five more dangerous assumptions next week.

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