Three Criteria For Picking Winning Stocks
Don't Spend All Of Your Time On Individual Securities
Key Ideas
- Learn the 3 criteria for picking winning stocks.
- Discover why asset allocation is the critical factor to investment success.
- Why you should spend 90% of your time doing market and sector analysis.
In our weekly “Ask Todd” series, a reader asks the following question:
“Todd, can you give me three quick criteria to sort individual stocks worth investigating from those that have no merit?”
In other words, how do we determine criteria for picking winning stocks?
The quick and dirty answer is: “your question has an underlying false premise.”
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The objective from investing is consistent profits – a favorable risk to reward ratio.
Every study ever commissioned agrees that 80-90% of the variance in returns from a reasonably well diversified portfolio results from asset allocation – not individual security selection.
The Key Is Asset Allocation – Not Picking Winning Stocks
What that means is focusing on individual security selection is focusing on the last 10%-20% of investment return.
It's Pareto's Law in reverse. You're spending 90% of your time focusing on 10% of the results.
Instead, you want to spend your time where 90% of your returns come from: market and sector analysis.
The reason it works this way is simple: individual securities within any given sector or market exhibit a fairly high degree of correlation. When they are highly correlated, it's difficult to add value.
However, with that said, the one exception where individual security selection holds merit is when it's valuation driven – classic Graham/Dodd, Warren Buffett type stuff.
Valuation is a valid risk management tool that also adds value through reversion to the mean, but it's still not a replacement for what drives the bulk of portfolio returns: market and sector analysis.
If you aren't clear on this, then just examine the returns for any of the current “Deans of Valuation” – Warren Buffett included.
Every time the market tanks the value guys all endure statistically meaningful drawdowns. Individual stock valuation is no savior for the value kings because market risk overwhelms individual security selection.
It's just the way the math works.
In summary, the order of importance for performance drivers is as follows: market risk, then sector risk, then individual security risk.
Don't disrespect Pareto's Law by spending 90% of your time on the last 10% of return (individual securities).
There are very few investors who can succeed with stock picking, and even the best get overwhelmed by market and sector dynamics.
Instead, focus all of your efforts on the 10% that produces 90% of your results – asset allocation and risk management.
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