Improving Confidence

At the heart of it all, skilled investors have to do two things well — pick the right stocks, and trade them well.

To tell us whether an investor is skilled at picking stocks, we use a metric we call the winning percentage. It is simply the number of profitable stocks divided by the total number of stocks that an investor has ever put into their model portfolio. An investor with a winning percentage of 85% is someone who puts a lot of effort into stock selection and is doing a very good job.

To determine whether an investor is skilled at trading we use a metric we call the average gain to average loss ratio. We calculate it by taking the average gain from all the winners and dividing by the average loss from all the losers. A ratio of 2 means that the investor makes twice as much money when they are right about a stock as they lose when they are wrong. This investor is doing a good job of selling the losers before the losses become large, while also letting the winners run.

Putting it Together

Consider two investors who each delivered the same alpha over the last five years. Many would say they are equally skilled but also equally likely to be lucky.

But, what if I told you that one investor’s alpha came from a single trade (buying Google at its IPO) and the other made hundreds of trades of which 85% of the stocks were profitable, and the average gain to average loss ratio was 2? Would this information change your confidence in one versus the other?

It does for me. Although we use alpha as a measure of skill, it is not a good estimate of future returns because it is the result of past opportunities that may no longer be available. We should not expect that future opportunities will be the same as in the past.

However, a winning ratio of 85% and an average gain to average loss ratio of 2 tells us that the investor has good judgment about stock selection and trading decisions. I have more confidence that the investor will apply the same judgment in the future as in the past, than that he will achieve comparable alpha.

It is metrics like these (and others) that go well beyond what is typically available about mutual fund managers that improve our confidence that the investors we are selecting are skilled. 

Putting Theory into Practice

From our coin-flipping analogy we learned that if we want to outperform an index fund, our chances are better if we use a team of skilled investors rather than just choosing the one with the best track record. Our data shows that skilled investors exist, but they are rare. Based on our analysis and, after additional due diligence, we have selected and signed research contracts with roughly 500 investors who have demonstrated a high level of skillfulness. It is from this group that we select our research team, which we call the “m100.”

Our coin-flipping analogy also teaches us that no matter how good someone’s track record looks, there will inevitably be some lucky people mixed in with the skilled ones. For this reason, when we select someone for the m100, we make it clear from the outset that ongoing membership is at our discretion. This arrangement allows us to correct mistakes, and gives us more flexibility than any other portfolio manager to change our research team as the landscape of market opportunities changes.

Finally, just as none of the 100 coin-flippers needs to throw 10 heads in a row a second time in order to for the group to beat all 42,000 people in the stadium, none of the m100 has to repeat their stellar performance in order for the m100 to outperform an index fund. If the m100 possesses above-average skill, we can be confident that, over a reasonable investment horizon, they will outperform the average investor -- which is what an index fund will mirror.  

The Acid Test

The acid test of any active strategy is whether clients get a better return than an index fund. Since November 5, 2001, we have put this strategy to the test by using it to manage a mutual fund. I cannot say much about the fund without turning this into a marketing piece. However, I can give you navigational links to the information you need to determine if this strategy passes the acid test. Click here to go to Morningstar’s webpage for our fund. Click here to go to the fund’s website.

If you would like to know more about how we find and manage skilled investors, contact me at ken.kam@marketocracy.com. Or, if you will be attending the NAPFA conference in Long Beach, look for David Diesslin. Dave is on our Board of Directors and is quite knowledgeable about everything we do.

Ken Kam
President
Marketocracy Capital Management, LLC

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