The Babe Ruth Style Of Investing In Your Stock Portfolio

babe ruth

If you’re in a hurry and don’t have the time to make it through this article, here’s the entire point in one sentence: Almost everyone is trained to think linearly in a way that suggests the frequency of getting investment correct is the most important individual endeavor, when really, it is the magnitude of our investments that matter.

For instance, an aspect of Benjamin Graham’s legacy that is almost never discussed is that over half of his lifetime success came from his decision to break all of his self-imposed rules about value and diversification to make a big $712,000 bet on GEICO in 1948. That changed his life—no way The Intelligent Investor becomes the bible to investors that it is today if Graham didn’t make his big bet on GEICO—although Buffett citing Chapter 7 and 20 with such regularity might have given it a fighting shot. The irony, of course, is that Graham is highly associated with buying something cheap and then selling it at the moment it reaches a value that reflects what it’s really worth—perhaps that’s an incorrect legacy—it is owning a lucrative asset and letting it grow, grow, grow that may be the more meaningful lesson from Graham’s life.

To quote the oft-ignored passage of The Intelligent Investor:

“In 1948, we made our GEICO investment and from then on, we seemed to be very brilliant people. Ironically enough, the aggregate of profits accruing from this single investment-decision far exceeded the sum of all the others realized through 20 years of wide-ranging operations in the partners’ specialized fields, involving much investigation, endless pondering, and countless individual decisions.

Are there morals to this story of value to the intelligent investor? An obvious one is that there are several different ways to make and keep money on Wall Street. Another, not so obvious, is that one lucky break, or one supremely shrewd decision – can we tell them apart? – may count for more than a lifetime of journeyman efforts. But behind the luck, or the crucial decision, there must usually exist a background of preparation and disciplines capacity. One needs to be sufficiently established and recognized so that these opportunities will knock at his particular door. One must have the means, the judgment, and the courage to take advantage of them.”

Michael Mauboussin, of Turtle Trader, calls this the “Babe Ruth” effect of investing and sums it up much better than I can:

A well-known and very successful portfolio manager recently told us a story that initially sounded incongruous. He explained that he was one of roughly 20 portfolio managers running money for a company. The company’s treasurer, dismayed with the aggregate performance of his active managers, decided to evaluate each manager’s decision process in an effort to weed out the poor performers. The treasurer figured that even a random process would result in a portfolio of stocks with roughly one-half outperforming the benchmark (in this case the S&P 500) and the other half underperforming it. So he measured each portfolio based on what percentage of its stocks beat the market.

The portfolio manager found himself in an unusual position. While his total portfolio performance was among the best in the group, he was among the worst based on this batting average. After having fired all of the other “poor” performing managers, the treasurer called a meeting with this portfolio manager to sort out the divergence between the good performance and the “bad” batting average.

The portfolio manager’s explanation for the discrepancy underscores a lesson inherent in any probabilistic exercise: the frequency of correctness does not matter; it is the magnitude of correctness that matters. Say that you own four stocks, and that three of the stocks go down a bit but the fourth rises substantially. The portfolio will perform well even as the majority of the stocks decline.

Building a portfolio that can deliver superior performance requires that you evaluate each investment using expected value analysis. What is striking is that the leading thinkers across varied fields—including horse betting, casino gambling, and investing—all emphasize the same point. We call it the Babe Ruth effect: even though Ruth struck out a lot, he was one of baseball’s greatest hitters.

The reason that the lesson about expected value is universal is that all probabilistic exercises have similar features. Internalizing this lesson, on the other hand, is difficult because it runs against human nature in a very fundamental way. While it’s not hard to show the flaw in the treasurer’s logic, it’s easy to sympathize with his thinking.

In a lot of financial literature, you often hear the experts say things like “you should take a little off the table” or “no one ever went broke taking a profit” that says things like “well, you bought it at $15 and now it’s at $25, might as well sell some so you’re only playing with house money.” It’s a misguided attempt to cater to our notion to permanently seal a particular stock as a winner (after all, if you hold indefinitely, a great investment could go down far enough for a long enough time that it is taken away and no longer ceases to be such a great investment) and caters to the notion that 10% annual returns are created by collecting assets that all perform in the 8-12% range.

No, the Pareto Effect can often extend to portfolio construction as well (the Pareto Effect refers to the tendency that 20% of a group produces roughly 80% of the results). If you go in-depth into the speeches from Warren Buffett, John Templeton, Charlie Munger, and to a lesser extent, Donald Yacktman and John Neff, you will notice a counterintuitive theme emerge in their writings: they speak about diversification in “at cost” terms. They say things like, “We don’t usually put more than 5%, 10%, or 15% into a particular for money that we are managing on behalf of others” (Note: Buffett broke this guideline twice in his life, first when he put over a quarter of his partnership’s assets into American Express, and later, when he joined forces with Graham and put 65% into GEICO).

Why do they do that? It’s because they recognize that high-performing assets don’t just give you one burst of capital appreciation fueled by profit growth, but they often keep at it for extended periods after that. If, at some point in your life, Tiffany jewelry has entered your stock portfolio, you don’t let an asset like that go. It’s been compounding to the tune of 17% annually since 1987; quietly building significant wealthout much fanfare. If it becomes something unwieldy like 30% of a portfolio, the answer is to divert the dividends elsewhere and increase your savings rate into other stocks, naturally watering down the effects that Tiffany has on your portfolio. That’s not the textbook advice on the topic—not at all. But when you look at what the masters of investing have to say, they don’t encourage you to sell high-performing assets, take a capital gains tax, and then cease to benefit from its continued growth over the long haul.

Sticking with losers too long and abandoning winners is quite problematic, and doesn’t get discussed as much as it deserves. That’s a shame. I understand why that’s the case; a $1 of loss hits people a lot harder than a $1 of gain. I couldn’t find the study I read, but somewhere along the line, I came across (I think it was a DALBAR study?) that said something to the effect of, “The interval of joy experienced from an investment going from $10,000 to $20,000 is equal to the same interval of unhappiness generated from seeing an investment go from $10,000 to $8,500.” People’s aversion to risk, which is very understandable, is not a psychological condition without consequences. Selling a Disney, IBM, Visa, Becton Dickinson, McDonald’s, Tiffany, or other similar stock simply because it went up a lot during your holding period is a decision-making framework that is going to lead to regret more often than not. It’s much better to divert dividends elsewhere and water down the effects of your investment with your new freshly available funds than to be quick to discard a high-growth asset that is in the process of changing your life.