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The myth of stock picks

David James |  01 April 2015  |  Investing

mythWhen people think they know better than the market, they are making a big leap of faith in themselves. Because it is them versus, usually, millions of others. As this article in the AFR points out, the notion of a stock tip rests on the idea of specialist knowledge. But does such knowledge even exist?

 

Share tips are a great Australian tradition, whether they're passed on by your brother-in-law at a dinner party or by a stranger in an online chat room. The obvious problem for investors is: do you just take the bait?

"Always remember, when you buy a stock, someone else has to believe just as passionately that it's a sell," says Elio D'Amato, chief executive officer at financial research firm Lincoln Indicators, which operates the Stock Doctor fundamental analysis subscription website.

"Investment requires a lot of work and following tips from a workmate is just not going to work. You might get the odd one right through sheer luck, but it's not going to make you money in the long run."

D'Amato says investors have to understand the business behind the stock, what it's worth and what its risk level is. But even before that, he says they have to understand what kind of investor they are – a trader or a long-term investor.

For a start, investors have to understand the share price "means nothing", he says, other than what entering the stock will cost you. Nor does the usual method of expressing a stock's risk, its standard deviation measure (volatility of the share price around a mean). "When it comes to risk, the actual risk of an investment is the financial risk of the business."

 

Even the idea that you have to do a lot of hard work to get things right is questionable. Remember, there are many opinions that go into making up a stock price. Are all of them worse than yours?

 

Skaffold uses consensus analysts' forecasts for future cash flows, earnings and dividends. "While that's not perfect, we try to get input from a range of experts in the market and look not just at the average but also the range," Batchelor says.

"If there is a wide range, you know there's not a lot of confidence in the forecasts, whereas a tight range implies a reasonable degree of predictability about this business. You can be a lot more confident in whatever numbers come out of your model."

The idea is also to capture growth prospects, he says. "It's one thing to say this business is at a discount to its intrinsic value today, but you also have to know what are the prospects for that business going forward. What if it's low-growth? We might be prepared to pay more for a business if it has great growth prospects than we would for a business that is just steady."

Batchelor agrees standard deviation of the share price "doesn't tell you a whole lot" about the intrinsic risk of a business. "We're certainly interested in volatility, but to us that means the volatility of the company's earnings. Woolworths is much more steady in its earnings than an iron ore miner is."

 

It is nice to pick the right timing to enter the market. But there are limits on all stock picking, limits that come with being only one person amongst many in the market trying to get it right. And even those 'value' calculations are only based on historical data, they say nothing about what matters -- the future.

 




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