Alan Merrigan
It's easy to think of history's greatest investors as nearly infallible strategists who rarely make mistakes. After all, if people like Warren Buffett and Peter Lynch and Martin Zweig have amassed hundreds of millions - and in some cases billions - of dollars, they must be correct the vast majority of the time. Right?
Wrong. While they likely make good calls more often than bad calls, the truth is that even great investors lose money on a sizable portion of their stock picks. When you are dealing with a financial machine that has as many moving parts as the stock market, expecting to be right on 100 per cent of your picks (or 90, 80 or even 70 per cent of your picks) just isn't realistic.
It's also not necessary - and, in fact, it can be quite dangerous.
One of the gurus I follow who stressed this point is Martin Zweig. During the 15 years it was monitored, Mr. Zweig's stock-picking newsletter was ranked number one according to risk-adjusted returns by Hulbert Financial Digest, averaging gains of 15.9 per cent per year. But Mr. Zweig wasn't perfect. He didn't try to be.
Mr. Zweig chose stocks using what he termed a "shotgun" method, which involves screening thousands of stocks against specific quantitative investment criteria to find those that make the grade. This was in contrast to what he called the "rifle" method, which involves analyzing a small number of stocks very thoroughly, looking not only at fundamentals but also at non-quantitative aspects.
When you're screening through thousands of stocks, you're going to end up buying some that end up being busts, and Mr. Zweig found that his approach had a built-in error rate of about three-eighths over the long term. "That is, out of eight stocks that I pick, three, or 38 per cent, will underperform the market," he wrote. Of course, it would be great if you knew ahead of time which stocks fell into that 38 per cent. But no one can do that - and Mr. Zweig showed that you don't have to. Beating the market 62 per cent of the time netted him huge profits.
Tilting the scales in your favour
Other great investors (Mr. Buffett comes to mind) use something of a rifle approach - and they make plenty of mistakes, too. But Mr. Zweig said the shotgun approach is probably more suitable for most people. I agree. For one thing, most investors don't have the time to perform in-depth research on numerous different companies. For another, a shotgun approach helps keep dangerous emotion out of your decisions, since you're sticking to the numbers - a stock's financials and fundamentals.
Mr. Zweig isn't the only guru I follow who used a shotgun method. Top hedge fund manager Joel Greenblatt does, too. His strategy targets stocks that are often beaten down but have strong fundamentals - though they could have non-quantitative factors that are driving them lower. "That's why you really have to buy a basket of 20 or 30, because I'm not sure anyone really knows the answer to each individual one of these companies," he said last fall. "On average they'll do quite well over a period of time, but I wouldn't want to select one or two individual stocks from that group."
Both Mr. Zweig and Mr. Greenblatt thus knew no stock-picker is perfect - they succeeded instead by tilting the odds of success, based on historical data, in their favour. That's what I do with my Guru Strategies, each of which is based on the approach of a different investment great, and my experiences with these shotgun-type methods have been in line with what Mr. Zweig and Mr. Greenblatt say. For example, since I started tracking it nearly seven years ago, my 10-stock Zweig-inspired portfolio has averaged gains of about 8 per cent per year, while the S&P 500 has gained just 2.5 per cent per year. But the portfolio's accuracy (which I define as the percentage of picks it makes money on) is about 56 per cent - far from perfect.
Similarly, my Greenblatt-based portfolio, which I started tracking in late 2005, has gained 11.4 per cent per year versus a decline of 1.5 per cent for the S&P 500, but it's been right on just over half (52.1 per cent) of its picks. And my top three strategies (those I base on the writings of Benjamin Graham, Tom and David Gardner, and Ken Fisher) have averaged annualized returns of almost 15 per cent since mid-2003, but the best accuracy rate among them is about 60 per cent.
Nobody's perfect
The bottom line is that if you're going to invest, you're going to be wrong sometimes - many times, in fact - whether you use a "shotgun" or "rifle" method. And if you try or expect to be perfect, you're much more likely to get rattled by those mistakes, making it more likely that your emotions will cause you to ditch a good strategy at just the wrong time.
But while you can't be perfect, "you can, however, be right more than you are wrong," Mr. Zweig wrote. "If you are right 60 per cent of the time, ride your profits, and rein in your losses, you'll find that when you're right you're very right, and when you're wrong you're only moderately wrong. In the long run, a 60-per-cent success rate translates into huge gains, a 50-per-cent rate into solid gains, and even a 40-per-cent rate can beat the market."
Wise words, regardless of what specific stock-picking strategy you use.