PROFITING FROM COMPLEXITY

H. L. Mencken is supposed to have noted, “For every complex problem, there is a simple solution, and it is almost always wrong.” Complex problems more often than not require complex solutions.

A complex approach to stock selection, portfolio construction, and performance evaluation is needed to capture the complexities of the stock market. Such an approach combines the breadth of coverage and the depth of analysis needed to maximize investment opportunity and potential reward.

Grinold presents a formula that identifies the relationships between the depth and breadth of investment insights and investment performance:¹⁰

IR is the manager's information ratio, a measure of the success of the investment process. IR equals annualized excess return over annualized residual risk (e.g., 2% excess return with 4% tracking error provides 0.5 IR). IC, the information coefficient, or correlation between predicted and actual security returns, measures the goodness of the manager's insights, or the manager's skill. BR is the breadth of the strategy, measurable as the number of independent insights upon which investment decisions are made.

One can increase IR by increasing IC or BR. Increasing IC means coming up with some means of improving predictive accuracy. Increasing BR means coming up with more “investable” insights. A casino analogy may be apt even if it is anathema to prudent investors.

A gambler can seek to increase IC by card counting in blackjack or by building a computer model to predict probable roulette outcomes. Similarly, some investors seek to outperform by concentrating their research efforts on a few stocks: by learning all there is to know about Microsoft, for example, one may be able to outperform all the other investors who follow this stock. But a strategy that makes a few concentrated stock bets is likely to produce consistent performance only if it is based on a very high level of skill, or if it benefits from extraordinary luck.

Alternatively, an investor can place a larger number of smaller stock bets and settle for more modest returns from a greater number of investment decisions. That is, rather than behaving like a gambler in a casino, the investor can behave like the casino. A casino has only a slight edge on any spin of the roulette wheel or roll of the dice, but many spins of many roulette wheels can result in a very consistent profit for the house. Over time, the odds will strongly favor the casino over the gambler.

A complex approach to the equity market, one that has both breadth of inquiry and depth of focus, can enhance the number and the goodness of investment insights. A complex approach to the equity market requires more time, effort, and ability, but it will be better positioned to capture the complexities of security pricing. The rewards are worth the effort.