You know what they say about assuming anything

Assumptions are the mother of all mistakes and here are five. Let's start with the basics.
By · 25 Aug 2012
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By ·
25 Aug 2012
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Assumptions are the mother of all mistakes and here are five. 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.

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 split second after you invest, everything changes, you simply accept it.

There's no "mistake", there is simply an outcome you have to deal with. If you narrow the odds you will win more than you 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 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 which challenges the idea of catching the knife or averaging down. What is more likely that a stock that falls 10 per cent is going to miraculously turn on a sixpence and go up for ever more, or that it's more likely that something is wrong and it is 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 that there is one month that is statistically the best month of the year and one month that is the worst. But it is just a statistic, it is not a prediction. You were bound to come up with a good month and a bad month. It adds no value at all. It is voodoo. Unless you can explain the reason a statistical phenomenon will repeat, it is of no value. Who cares if the stockmarket goes up in an election year and down in October. What about this year? Some of the "Sun Spot"-type predictions that lace the stockmarket are simply people with too much time and too much data on their hands. "Statistically nine out of 10 statements that begin with the word 'statistically' are utter rubbish."

Dividends are good.

Not necessarily. This is a bit complicated but basically 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. Really 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, not the best investments. The dividend decision can also be driven by a lot of factors that do not reflect success. Like 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 will not be forever. It is a purple patch. The bottom line is that you need to look at the total return from an investment (capital plus income) not yield. The yield is a distraction, it will distract you from the share price which is far more volatile, far more important and can do you far more damage than a dividend will do you good.

Five more next week.

Marcus Padley is a stockbroker with Patersons Securities and the author of stockmarket newsletter Marcus Today. For a free trial go to His views do not necessarily reflect the views of Patersons.

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