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January 20, 2006

Stock Picking

Did you ever hear this scam? The con artist picks 1024 names at random out of the phone book. He mails them each a letter that says, “I have a sure fire stock picking method that never loses.” In 512 of those letters, he tells them that the stock of ABC company will be higher a month from now and in the other 512 letters he tells them the stock of ABC is going to fall.

 

He sends a follow up letter at the end of the first month to the 512 people that got the right letter and he says, “I told you had a fool-proof stock picking system.” Then he predicts in 256 of the letters that XYZ is going to go up and in the other 256 letters that XYZ is going to go down.

 

He does this for five months in a row. The sixth month he sends out 64 letters that say, “I told you six months ago that I had a foolproof stock picking system. I have sent you six winning picks in a row. Put $100 thousand in an account with me and let me put this foolproof stock picking system to work for you!”

 

Next time you hear someone say their mutual fund has outperformed the market five years in a row I want you to think of these letters.

 

Let’s just do the math using round numbers. If there are 18,000 mutual funds and two-thirds of them, historically, have underperformed the market each year, then you would expect 6000 of those funds to outperform the market in year one. Of those, 2000 should beat the market two years in a row, 650 will beat it three years in a row, 215 will beat it four years in a row, and 70 will beat it five years in a row.

 

When someone tries to convince you that actively managed mutual funds are a good investment by citing these sorts of returns, you should understand this does not mean the person running the fund has some special skill as a stock picker. It is merely the laws of probability at work. You put enough people to work flipping coins and someone is going to flip five heads in a row.

 

The other thing you have to remember is that the stock picker can boost his odds of getting lucky by taking on additional risk. The Ultra OTC fund loaded up on risk and got lucky. They had 200% returns which shot them to the top of the charts for mutual fund returns. Money came poring in to the fund, which is after all, how the fund makes its money - by attracting assets - not by making you money. Two years later, it had lost 90% of its value. Surprise! Surprise!

 

You cannot look at performance of any investment without also looking at the risk it takes to get that return. The combination of the two is something called a risk adjusted return. The most common measure of risk adjusted return is the Sharpe Ratio. Let’s look at some numbers:

 

Let’s say you have two portfolios. One has returned 13% and the other has returned 15% over the same period. On the surface, you would think that the portfolio earning 15% had performed better. But let’s look deeper.

 

The statistical measure of risk in a portfolio is known as standard deviation. Suppose the portfolio earning 13% had a standard deviation of ±25%. The portfolio with the higher return also took on more risk giving it a standard deviation of ±40%. When we compute the Sharpe Ratio for each, taking both risk and performance into account, we see the portfolio with the lower return was actually the better investment on a risk adjusted basis.

 

Now think back to the last conversation that you had with your investment advisor. Did he sell you an investment based on historical returns? Those returns don’t mean that it will continue to perform; just that it did in the past.

 

Did he or she sell you a mutual fund or money manager based on a track record of solid performance? Remember, put enough people to work flipping coins and some number of them will flip heads five times in a row.

 

Did they compare funds on a risk adjusted basis? No? They didn’t talk to you about the level of risk in these funds? Red flags should be going up all over the place.

 

Now imagine if you had been armed with knowledge. Imagine that you had gone into these conversations knowing what questions to ask, what numbers to look at and what investments to steer clear of no matter what.

 

Finally, let me ask you this … what is the difference between your advisor selling you a mutual fund based on its stellar historical track record and the mail scam? One is considered a scam and the other a legitimate business practice. Puzzling!

 

What are your thoughts? Do you agree? Disagree? Chime in with your comment below.

 

Kim Snider, Kim Snider Financial Communications, Chronim Investments and/or Snider Advisors make no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Call 866-952-0100 to request the Snider Investment Method™ Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing. All investments are subject to risk including possible loss of principal.

Posted by Kim Snider on January 20, 2006 | Permalink

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