Key Points:
- The hit rate, or the percentage of decisions that make money, is an important metric for portfolio managers.
- However, a good payoff ratio can compensate for a low hit rate.
- Peter Lynch emphasized the importance of payoff, stating that one or two good stocks a decade can make a significant impact.
- Payoff is often overlooked by asset owners and allocators but is a critical factor in successful investing.
- The ability to cut losses and take profits is what sets successful investors apart.
- Assessing a manager’s decision-making skills based on their payoff is a more accurate measure of their skill.
- Using payoff as a comparative metric allows for a more objective evaluation of portfolio managers.
When evaluating portfolio managers, one commonly overlooked metric is the hit rate. The hit rate represents the percentage of decisions that make money, similar to a batting average in baseball. Many fund managers believe that as long as they are right slightly more than 50% of the time, they are successful. However, recent research suggests that most fund managers have a hit rate of less than 50%.
A study called “The Behavioral Alpha Benchmark” analyzed the trading behavior of 76 portfolios over three years. It found that only 18% of portfolio managers made more value-additive decisions than value-destroying ones. The study examined seven key areas of investment decisions: stock picking, entry timing, sizing, scaling in, size adjusting, scaling out, and exit timing.
While the hit rate garners significant attention, it is often less important than the payoff ratio. The payoff ratio measures whether a manager’s good decisions have typically made more than their bad decisions have lost. For example, a few decisions with payoffs well above 100% can compensate for several that fall below the 100% mark.
Peter Lynch, a legendary investor, emphasized the importance of payoff as a key theme in successful investing. He famously stated, “You only need one or two good stocks a decade.” This highlights the significance of ensuring that winners outweigh losers in aggregate.
Payoff is a pure skill metric that is often overlooked by asset owners and allocators. They tend to focus on various manager statistics to differentiate luck from skill, but payoff is a critical factor in assessing investment skill. Managers who consistently achieve a payoff over 100% demonstrate true investment skill by knowing when to hold and when to fold.
An important aspect of successful investing is the ability to cut losses and take profits. The best investors excel at this, leading to a high payoff ratio. This skill is crucial in maximizing returns and mitigating losses.
Assessing managers based on their payoff is a more accurate measure of their decision-making skills. It goes beyond evaluating past performance and focuses on the quality of their decision-making process. By considering the payoff ratio, investors can gain a better understanding of a manager’s skill and potential for future success.
In conclusion, when selecting portfolio managers, it is important to consider both the hit rate and the payoff ratio. While a high hit rate is desirable, a good payoff ratio can compensate for a lower hit rate. Payoff is an often overlooked metric that truly reflects a manager’s investment skill. By prioritizing payoff in manager selection, investors can make more informed decisions and potentially improve their overall investment outcomes.
