The Numbers Behind the Numbers
In this recent post I discussed some of the statistics behind investment outperformance, and made the observation that in recent years, the stocks selected for inclusion in The Montgomery Fund have outperformed the market only 54 per cent of the time. While we get more right than we get wrong, the actual percentage of stock picks we get right is perhaps smaller than most people might think, and this is likely to hold true for most, if not all, investment managers.
Today, let’s fill in a bit more of the picture to better understand how we have been able to generate pleasing investment returns despite what looks to be a less-than-impressive hit rate.
Perhaps the most important thing that this success rate statistic doesn’t tell you, is how much benefit we extract from each successful pick, and how much we lose on each unsuccessful call. If our good stock selections are able to generate much larger profits than the losses incurred on the weak selections, we would still achieve outperformance, even if we were to get the same number of calls right as we get wrong.
Clearly, we would hope to be able to extract more benefit from the winners than we lose on the losers. For one thing, our portfolio construction methodology gives more weight to what we perceive to be the better ideas, and that on its own should mean the winners add more than the losers subtract. Also, if we can identify mistakes early, we should be able to contain their impact.
In addition to this, the natural skewness of equity returns will also affect the numbers, and will tend to boost the profitability of good calls (as well as holding back the 54 per cent number). It may help you to get your mind around this if you consider the following: Over (say) a one-year period, there will not be any stocks that return less than -100 per cent (a complete loss of value), but there will be some stocks that return more than +100 per cent. The tail of the distribution is stretched to the right, which means that in for the market as a whole, the average “winner” outperforms the market by more than the average loser underperforms.
Without wanting to get too bogged down in the statistics, a corollary of this is that most stocks actually underperform the market. If the winners win more than the losers lose, there must be more losers than winners for the average return to equal the average return.
A look at the data shows that the amount The Montgomery Fund has made on average from its successful picks has indeed been substantially higher than the amount surrendered on the underperformers. In fact, in recent years the ratio has been around 1.9x, meaning each winner has contributed almost twice as much as has been given up on each of the poor choices.
Hopefully this helps to explain why The Montgomery Fund has delivered good overall results despite a significant percentage of stock selections not turning out as we would have hoped. There are no guarantees in equity market investing, but if we can keep these ratios at similar levels into the future, we should be able to continue to deliver a very satisfactory return profile for our investors.
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.
Peter
:
Hi Tim, Thanks for sharing the numbers – they are very interesting. Are you also able to share the percentage of profitable versus loss-making stock picks? I track this figure in my results, so am interested to see how that compares, although I don’t track each stock pick to the market (I only compare my portfolio as a whole to the market).
Tim Kelley
:
Hi Peter. the previous article (see link at the top) should give you the information you need on percentage of profitable trades.
colin jones
:
A 54% prospective success rate is pretty good. As a medical subspecialist, if I made an uncommon diagnosis for a patient first off (prior to investigation and followup) in more than 50% of the cases of that diagnosis, I was doing much better than average. As you say, it is how you manage the follow up that counts.