Luck vs Skill
In concept, an investor has a universe of stocks from which to select a portfolio. If an investor’s portfolio delivers a higher return than a portfolio consisting of the entire universe of stocks, then the excess return — also known as “alpha" — can be attributed to the investor’s skill. Investors who don’t deliver alpha can be excluded from further consideration.
Of the investors who generated alpha, it is certainly possible that any of them could just be lucky. However, the larger the alpha, and the longer the track record, the less likely that is the case. And, because we have so much more data, we have developed other metrics that increase our confidence that we are finding skill.
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.