Data vs Anecdote
In my view, the role of chance in equity investing is one of the most important concepts a successful investor needs to grasp. It’s also one that pretty much everyone seems to forget – sometimes even seasoned investment professionals.
To illustrate, imagine that an investor sets out for us a reasoned argument for why a particular stock should do well, and, intrigued by their assessment, we then follow the stock. Some months or years down the track we note that the stock has done exceptionally well, and has a register of happy investors.
Our natural inclination at that time is to think that the investor who set out the initial thesis is probably someone to be taken seriously; an investor who has a grip on what stocks do well and why. Someone who we should pay attention to when next they opine on a stock.
In reality, what we can reliably conclude from this evidence is zip. Nothing. Nil. The reason for this lies in the statistics of stock picking.
In The Montgomery Fund, for example, we’re proud of our track record: in the 3 and a half years since inception it has beaten the market by a large margin, and with lower risk. However, we didn’t achieve that by getting everything right. Far from it. If you analyse our individual stock picks over the last few years, you find that we got a measly 54 per cent of them right.
That’s less than five and a half good calls for every ten calls made.
What that means is that if you sample one of our historical stock picks at random, the chance it was a dud is just under 50 per cent; not much different to a coin toss. As a result, there will no doubt be many people who have heard us extoll the merits of a stock in the past, only to see it fall. Their natural inclination would be to conclude that we possibly don’t know what we’re doing.
The reality of successful equity market investing is that a small statistical edge is about all you can ever hope for. Markets are full of smart people trying to find the best investments, and not much gets past them. The good news is that a small edge applied consistently time and time again is enough to generate very good results. It won’t pay off every month (for TMF it has historically paid off in about 53 per cent of months) or even every year. However, applied over large numbers of individual calls and long timeframes, statistics start to work in your favour, and that edge delivers the goods.
So, beware the anecdotes and the stories. Separating skill from luck requires an awful lot of data (and data is not the plural of anecdote). If you do your own stock-picking, then apply your methodology consistently and ruthlessly, even (or especially) when luck runs against you, as it inevitably will sometimes.
As for our hypothetical investor, above, we are better off gauging the weight of her analysis and reasoning to determine whether it might contain the critical statistical ‘edge’. Judging from a single stock call is only marginally better than judging based on the flip of a coin.
Tim Kelley is Montgomery’s Head of Research and the Portfolio Manager of The Montgomery Fund. To invest with Montgomery domestically and globally, find out more.
Tim joined Montgomery in July 2012 and is a senior member of the investment team. Prior to this, Tim was an Executive Director in the corporate advisory division of Gresham Partners, where he worked for 17 years. Tim focuses on quant investing and market-neutral strategies.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
steven
:
Hi,
Following this blog, the 53% figure is a surprise, it would be interesting to know what the percentage would be if you adjusted it for the stocks that didn’t perform, but you were able to sell at break-even or higher from the original position.
Tristan Harrison
:
I am very interested in what you class getting the investment call ‘wrong’.
A fall in earnings per share?
A fall in share price? (If the investment case remains, isn’t that a good time to buy more and lower your average cost?)
If at some point in the future, if the company’s share price recovers above purchase price, would it go from a wrong call to a right call?
Tristan
Tim Kelley
:
Hi Tristan. That’s a good point. What we measured is simply whether an investment outperformed or underperformed the market during the period we had held it. There will be cases of sound investment decisions that will prove to be winners in the long run, but whose share price has suffered in the short term. Longer time frames as well as larger sample sizes can both help bring the “truth” to the surface.
Tristan Harrison
:
Hi Tim,
Thanks for your reply. I see that it’s the easiest way to measure the return..if you were to sell your investment (and the comparative index) at the same time. But I think you are doing yourself a disservice by calling it a wrong choice.
As a share price is a fluctuating price rather than reflecting a tangible number like actual earnings, it might not reflect the growth in earnings that your individual investment has over the average market’s rise in earnings over that time. I’m not sure how you’d measure that, perhaps some sort of ‘PEG achieved’?
I imagine if you did your same analysis based on how your investments have grown earnings more (with a value metric included somehow), it would show your investment choices have been better than 54%. But like you said, with time, your choices will show the truth with the share price.
Tristan
Roger Montgomery
:
I think you’ve nailed it Tristan. If we believe that in the short run prices can be random, then some of the “wrong” calls, if held for shorter periods might be attributed to chance or randomness too. I know the combination of quantitative and qualitative analysis we conduct turns up a better field of opportunities than chance too.
Craig Brown
:
There’s a statistical fact used by pro punters (horse racing) that goes something like this: “If your winning strike rate is 25%, over a series of 1,000 or so bets you are statistically guaranteed a losing run of 35-40 races at some point in that series.”
Your staking plan has to be able to handle that inevitable occurrence.
Any idea what the guaranteed losing run is on 53%?
John Boardman
:
That’s great information to know that 53% of the time you are right, otherwise we might get an impression that you pick the right stocks 100% of the time. I suspect it is also a case of cutting those losing picks early and letting the good picks run?
Tim Kelley
:
…and ideally having the larger positions in the portfolio tilted towards the best picks.