(image credit:  money.cnn.com)

We talked about what a great investor looks like, but how do we figure out who will be a good investor?  You gotta measure it to manage it, so do you look at how much money someone has made?  Their returns?  Or, more sophisticated, at an investor’s alpha or Sharpe Ratio?  These types of measures are the focus of fifty years of finance literature.  I can’t argue with their precision.  But if you care about future returns, we do know that they measure the wrong thing.

The traditional measures of investing prowess only measure the historical output.  In order to decide where to invest and create durable/improving investment performance you have to measure how the inputs make the outputs.  Just imagine sitting down with an investor for a year-end review and saying:  “Look you are doing OK, but we really need you to increase your returns in excess of the risk-free rate divided by the historical standard deviation of returns by at least 0.2 in the next year (Sharpe Ratio).”  Where would one even start with that?  It’s not actionable for an investor.  Like alpha, the Sharpe Ratio is a vanity metric – a figure that looks good for your end customers (limited partners), but has little to do with how to effectively deliver that product consistently to customers in the future.

If that wasn’t clear, consider another example, suppose GM exclusively measured their entire organization based on the finished vehicle.  In this case, vehicles would never get built because no one would know what to do.  To make the final product, you need to measure the performance of the various pieces of the production process in the ways that are under the control and are relevant to each part of the process.  People making seat covers need to be primarily measured on how many fault-free seat covers they can make per hour, rather than the JD Power rating of the entire vehicle.  If the interior, chassis, electronics, engine and assembly people are all executing well on their responsibilities, chances are they will make a great vehicle.  Not rocket science.

OK, so we don’t want to focus on the historical outputs, we want to measure how well the inputs are used, you get that.  What inputs should we measure then?  I will break them down one at a time, but to keep this short, I will give you the answer upfront and then show you how I got there.  The number one metric to measure is batting average.  Batting average, batting average, batting average.  In other words, the number of investments that an investor makes that are profitable divided by the total number of investments.  If an investor’s batting average over time is <50%, there are few ways to sustainably make money.  That is the breakpoint between success and a painful spiral.  A batting average <50% means that an investor will have to roll the dice for a few big winners and/or hope to allocate more capital to the winners than the losers.  It’s not sustainable or repeatable.

What is true about individual investors is true about investment organizations as well.  Obviously, if the aggregate investment organization’s batting average is <50%, they will need big winners or lucky capital allocation to perform.  But the batting average within the organization tells you even more.  If only a few partners have a batting average >50% or batting averages are declining among partners over time, that means that the partnership is sick.  If young analysts’ batting averages aren’t improving over time, that means the organization is not investing in training and/or recruiting.  In both cases, the great investment returns of the past are very unlikely to be repeated in the future even if the whole dollars, returns, alpha and Sharpe Ratio appear to be fine today.

It is clear that having a batting average >50% is at the core of making money investing, but is it an actionable metric?  Consider the year-end review to discuss a batting average:  “Look you are doing OK, but we really need you to increase your batting average from 40% to 60% next year.”  What do you do with that?  Well, go pick more stocks that go up than down.  What is the easiest way to do that?  Weed out the losers.  Do more of the winners.

In order to do that, you need to actually have data on when/where you win and lose.  I track my batting average by geography, market cap size, sector, industry and situation (IPO, spin-off, merger, etc…).  After a few years, an 80/20 emerges.  80% of my losses come from one particular type of investment .  So the actionable outcome is that I need to not trade those stocks or have the trading desk refuse to execute orders in those stocks.  In short, batting average is very actionable.

The readers of this post are smart, so I am sure a number of objections have started popping up in your heads.  Shouldn’t you measure batting average relative to the market?  Over what time frame should you measure the batting average?  Agreed.  So in an absolute return setting, a >50% batting average is what matters.  If you are long-only or benchmarked, then you gotta beat the batting average of the index.  If you are long-short, with certain exposure weightings, then you can benchmark against the index with those exposure weightings.  The same flexibility goes for timeframe.  If you care about performance over 3 years, then track batting average over 3 years, not year-to-year.  If you care about performance daily, then track the batting average every day.  A batting average is simple division, make it work for you.

Obviously, batting average does not = profits.  You gotta multiply the batting average times the exposure (the amount of money allocated to each investment) to get profits and we’ll go over measuring exposure in the next post.