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Their argument is that most stocks are mediocre, with a handful of big winners mixed in: that means building a portfolio of hand-picked stocks is likely to unde

Their argument is that most stocks are mediocre, with a handful of big winners mixed in: that means building a portfolio of hand-picked stocks is likely to underperform since it will probably miss the best stocks. But there's a symmetry argument there that the article misses. Surely I can make a portfolio that tracks the market, but excludes a handful of stocks I think are going to be lousy. Because I have most of the market in my portfolio, I'm likely to hit the big winners, and with high probability I'll ditch losers. To build on their poker chip analogy, what if there are four $10 chips, one $100 chip and I pick four chips each time instead of two?

madcaptenor 10y ago
But the distribution of returns isn't symmetric. With the losers, you can lose at most 100% of your investment; with the winners, you can make a lot more.
- sten 10y ago
  That's for stocks. You can always short and potentially have no limits for your loss.
notahacker 10y ago
This assumes your judgement on which stocks you think are going to be lousy is better than the market's overall. There might be rare occasions when that's justified (that company had major organizational issues when you worked there last month that aren't widely known, your technical knowledge means you know that hyped product probably doesn't work). But the rest of the time, you're just as likely to lose money overestimating how lousy the stock is as gain it. The $100 chip might well be the one you (and many other stock pickers) think is trending downwards until it pulls off that unexpected achievement. That said, you're right that excluding from a portfolio is a lower volatility strategy and much safer than shorting the "lousy" stocks. If I have reason to believe $TECHSTOCK is about to have their lunch eaten by new competitors and leave it out of my portfolio I slightly outperform the market if I'm right, and don't lose my shirt if Google buys it.
bluGill 10y ago
the problem is there are 4 $10 chips, 1 $100 chip, and 3 $-50 chips. Pick a $-50 chip and you are negative - note that in this market most chips will make you money, the total loses - I just picked my numbers at random. Now a good manager should be able to look at the signs: most companies that will lose money have plenty of warnings in their various (10k, 8q or whatever) reports, not to mention you can look at an industry and see trends that hit the bottom line. Should is key: many managers fail at this. However becareful when rating failures: the best managers long term have many years of below average performance - not just below market, below their peers are ultimately are not good. The best returns are from seeing a company that is doing bad now, but is going to turn things around in a few years (if you are a large enough you can even force this: buy enough of a company that you can change management). However this often means seeing that a turn around will happen sometimes in the next 5 years and waiting our 3 years of bad returns (and looking really bad!) before it happens. I cannot tell who the best managers are, except in hindsight though.
skybrian 10y ago
I've often wondered the same, but presumably the numbers don't work out. Part of the problem might be if some big gains come from apparent losers that somehow manage to pull a rabbit out of a hat.

madcaptenor 10y ago

But the distribution of returns isn't symmetric. With the losers, you can lose at most 100% of your investment; with the winners, you can make a lot more.

sten 10y ago
That's for stocks. You can always short and potentially have no limits for your loss.

notahacker 10y ago

This assumes your judgement on which stocks you think are going to be lousy is better than the market's overall. There might be rare occasions when that's justified (that company had major organizational issues when you worked there last month that aren't widely known, your technical knowledge means you know that hyped product probably doesn't work). But the rest of the time, you're just as likely to lose money overestimating how lousy the stock is as gain it. The $100 chip might well be the one you (and many other stock pickers) think is trending downwards until it pulls off that unexpected achievement. That said, you're right that excluding from a portfolio is a lower volatility strategy and much safer than shorting the "lousy" stocks. If I have reason to believe $TECHSTOCK is about to have their lunch eaten by new competitors and leave it out of my portfolio I slightly outperform the market if I'm right, and don't lose my shirt if Google buys it.

bluGill 10y ago

the problem is there are 4 $10 chips, 1 $100 chip, and 3 $-50 chips. Pick a $-50 chip and you are negative - note that in this market most chips will make you money, the total loses - I just picked my numbers at random. Now a good manager should be able to look at the signs: most companies that will lose money have plenty of warnings in their various (10k, 8q or whatever) reports, not to mention you can look at an industry and see trends that hit the bottom line. Should is key: many managers fail at this. However becareful when rating failures: the best managers long term have many years of below average performance - not just below market, below their peers are ultimately are not good. The best returns are from seeing a company that is doing bad now, but is going to turn things around in a few years (if you are a large enough you can even force this: buy enough of a company that you can change management). However this often means seeing that a turn around will happen sometimes in the next 5 years and waiting our 3 years of bad returns (and looking really bad!) before it happens. I cannot tell who the best managers are, except in hindsight though.

skybrian 10y ago

I've often wondered the same, but presumably the numbers don't work out. Part of the problem might be if some big gains come from apparent losers that somehow manage to pull a rabbit out of a hat.