As investors, we have all had our fair share of bad experiences with the stock markets. From alleged management fraud to the global financial crisis, the recent covid pandemic and sometimes just our stock picks just don’t work the way we thought they would! Let us reveal to you a little secret. Investment professionals have these experiences too, but they are really good at hiding these facts.
Fun fact, top investor Warren Buffett has a success rate of only 58% when it comes to choosing the right stocks. In fact, in fund management, this ‘hit rate’ is absolutely enviable! Buffett once mentioned that even if an investor only hits 50% of the right stocks in his entire portfolio, meaning the other half would be rotten, he would still be able to earn supernormal returns!
Imagine that you have selected 10 stocks for your portfolio through your hard work and research and have patiently held it for a long period of time, such as the next 40 years. Now, compare the first case with the scenario in which five out of 10 stocks in your portfolio performed exceptionally well, generating a CAGR of 15-30%. While the other half of the portfolio completely eroded the shareholder’s assets. An interesting observation is that the compound return of true stocks is higher than the loss of other stocks and if held for a long period of time, the investor’s capital increases progressively over time. Yes, that’s right, winning stocks proved more than capable of overcoming even the negative 100% returns of losers, earning an overall positive return on the entire portfolio in the long run. In fact, the returns keep increasing as he keeps increasing the time frame of his investment, thanks to the power of compounding!
Now, consider a second scenario in which, even after thorough research and conviction, the investor’s choice in all but one stock turned out to be completely wrong. You can imagine, all my money goes down the drain! But the results will surprise you! Turns out, even if your faith in a single stock turns out to be true and you stick to it, you are bound to earn great returns in the long run! Meaning, even if one stock gives 30% CAGR and others lose 100% completely, your entire portfolio is bound to earn a healthy 22.73% return for the next 40 years. Not only does the compound return of a right stock have the power to outperform other loss-making bets, but can also change the overall investment performance of your portfolio over the long term.
Even more fascinating is the fact that in just a few short years, the entire portfolio begins to exactly reflect the performance of the winning stock! Why does this happen? The answer is simple, limited downside risk and unlimited upside potential! Sure, losing nine shares could cause your investment capital to disappear entirely from those respective stocks. In the worst case, they can be reduced to zero, but that’s about it; Your downside risk is capped at zero. Investments certainly can’t fall further than zero, right? However, for our perfect pick to win, the sky is the limit! Year after year, your investments in winning stocks will keep making money, accelerating your returns from stocks, all thanks to the magic of compounding!
The conclusion is clear: If you have fallen victim to some wrong stock picking, fear not. Picking a winning stock is a daunting task, given the uncertainty about how companies compete, expand and adapt, potential technical disruptions, the impact of regulations, an out-of-the-blue pandemic-list. is endless. So, don’t worry about picking a losing stock. We can never have the upper hand when it comes to predicting the future! Accuracy in stock selection may not be under our control. But due diligence and thorough research certainly is.
Hence, it is best that we dedicate our time and attention to study the stock, getting a complete understanding of the business, its risks and opportunities and financial position. Everything else is a game of patience! Our patience will bear fruit in the long run.
Saloni Desai is Senior Equity Research Analyst at Mott Financial Services Pvt Ltd. Ltd.
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