Richard Beddard recently wrote a blog post about company strategy. And Nate Tobik recently wrote one about how you – as a stock picker – have no edge. I’d like you to read both those posts first. Then, come back here. Because I have something to say that combines these two ideas. It’ll be 3,000 words before our two storylines intersect, but I promise it’ll be worth it.
Stock Picking is Like Playing the Ponies – Only Better
Horse races use a pari-mutuel betting system. That is, a mutual betting system where the bets of all the gamblers are pooled, the odds adjust according to the bets these gamblers place, and the track takes a cut regardless of the outcome.
At the race track, a person placing a bet has a negative edge. He places a bet of $100. However, after the track takes its cut, it may be as if he now “owns” a bet of just $83.
At the stock exchange, a person placing a buy order has a positive edge. He places a bet of $100. However, after a year has passed, it may be as if he now “owns” a bet of $108.
All bets placed at a race track are generically negative edge bets. All buy orders placed at a stock exchange are generically positive edge bets.
In horse racing, the track generally has an edge over bettors. In stock picking, the buyer generally has an edge over the seller.
In the Long Run: The Buyers Win
The Kelly Criterion is a formula for maximizing the growth of your wealth over time. Any such formula works on three principles: 1) Never bet unless you have an edge, 2) The bigger your edge, the more you bet and 3) Don’t go broke.
In theory, the best way to grow your bankroll over time is to make the series of bets with the highest geometric mean. Math can prove the theory. But, only in theory. In practice, the best way to prove whether a system for growing your bankroll works over time is to back test the strategy. Pretend you made bets in the past you really didn’t. And see how your bankroll grows or shrinks as you move further and further into the back test’s future (which is, of course, still your past).
Try this with the two “genres” of stock bets:
1) The 100% buy order genre
2) And the 100% sell order genre
Okay. You’ve run multiple back tests. Now ask yourself…
Just how big was your best back test able to grow your bankroll over time by only placing buy orders – that is, never selling a stock. And just how long did it to take for your worst back test to go broke only placing buy orders.
Now compare this to back tests in the sell order genre.
Just how big was your best back test able to grow your