January 29, 2002 Credit Suisse First Boston : The Babe Ruth Effect: Frequency vs. Magnitude

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 (read more…)

CATEGORY: valuation, VC, winner take all