Stock picking is not the key… Capital allocation/ management is !

After being in markets for almost 20 years, this is what I firmly believe now. Read on... maybe you will agree too...

I got first exposed to equity investing way back in 2000 during my Chartered Accountancy (CA) days. Since then every book I read and every person that I met – the general learning and discussion has always been centered around identifying good companies to invest into. Even today, the starting point (and mostly the ending point) of any conversation on the subject is – which stocks should one buy !

All of us have Warren Buffett as our role model and how he accumulated his wealth investing into good strong businesses. Logically therefore, the value of identifying and investing into good businesses can not be disputed.

Can it be ? obviously not…

Underlying meaning of investing itself is to buy something that can grow over time which can only happen if the business is good

So then why undermine stock picking?

Please read the title again… I nowhere undermined it… I only said it’s not the key !

And this realization happened to me couple of years back only when I was trying to reflect on my past experience and performance. Reasons –

  • Despite a very good stock picking record, I was only delivering mediocre returns
  • I was not alone, the situation was same with most others that I knew or whose performance I was tracking. The exceptions per se were far and few. Let me also state here that over the years, I have interacted/ known/ observed some of the best minds in this industry.

And what’s the main reason for this under performance…

We over estimate our capability to pick the winners and then become emotionally attached to them. In the process we forget to differentiate between winners and losers and somewhere lose control of our capital management and hence returns.

  • In general, the ability of anyone to pick winners vs losers ranges in between 40% to 60%. That is 4 to 6 winners out of every 10 stocks that he chooses. I don’t know anyone who is better than 60%. I also don’t know anyone who is worse than 40% !
  • However, we become complacent and believe that every stock that we have picked has to win and there is no other way.

Following are the four kind of stocks that most of us typically end up investing into –

Likewise, I have come across four kind of investors over the years.

Please note above investors (other than PI who are mostly fundamental) can be fundamental or technical or a combination of both. The stock picking approach really doesn’t matter. I have seen sufficient number of success and failures in either of the approaches. What differentiates them is how much disciplined they are in accepting that they can be wrong and accordingly manage their capital.

As mentioned before, irrespective of the kind of investors, generally the hit to miss ratio is between 40-60% i.e., on an average 50%. This is in terms of number of stocks. Capital allocation is the real difference between them

Have a look at the following table –

A more efficient capital allocation towards winners vs losers is what creates a huge difference in the underlying performance. To achieve the same, one needs to –

  • Accept that he can be wrong in stock picking and book losses; and
  • Allocate more capital towards winners at higher prices

Typical investing journey of different kind of investors –

No investor is immune to market movements and/ or ever changing business dynamics. However, what one can try controlling is a better capital allocation towards winners as compared to the losers.

Stock picking is based on various assumptions and is limited by our own capability, skill sets as well as external environment. Yes, we can and we should keep working towards improvising our stock picking capabilities – however, what is more important is how we are allocating/ managing our capital.

We actually have better control over capital allocation than stock performance

Ultimately what matters is how much return one generates and not how many times he was right !

Think about it… discuss this with people you have faith upon… and let me know your experience/ views/ suggestions. Please feel free to leave a comment or connect with me on nitin@candidcap.com

Other related posts that might be of interest –

  1. Most simple strategy to identify and analyze stocks
  2. Samvat 2076 begins: 10 pointers to success in the stock markets
  3. Average Down or Average Up – Which investing strategy makes sense?

Illustration Credit: Vecteezy.com

 

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About the author

Nitin Jain

A finance professional with around 20 years of investing experience in Indian markets both on buy and sell side, equity and debt, private and public with some of the best organizations globally including Goldman Sachs, ICICI Group, ICRA and others. He is a All India Silver Medalist CA by qualification.

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Shailesh
Shailesh
26 days ago

Good article …Nitin…this exactly makes a difference in consistency and long term goals.

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