Season Investments

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What Babe Ruth Teaches Us About Investing

Posted on July 10, 2012

Baseball is a game of statistics. More numbers, percentages and ratios are tracked in baseball than perhaps in any other sport, and the “batting average” is probably the most common statistic of them all. The batting average is defined by the number of hits divided by at bats and simply reflects the percentage of time a particular batter has gotten a hit. While the batting average is a good reflection of a hitter’s consistency, perhaps a more interesting measurement is the “slugging percentage” which is defined by the total number of bases divided by at bats. This statistic is a better depiction of the power and productivity of a batter.

Comparing the two batters in the table below reveals an interesting insight. While Batter 1 is more consistent and has a higher batting average, Batter 2 is actually far more productive by virtue of the fact that he tends to gain more bases on average when he connects with the ball. Therefore, one might accept a lower batting average in anticipation of a higher overall reward over time.

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While there have been a number of baseball players that have shown more consistency at the plate, Babe Ruth holds the all-time record for career slugging percentage and is widely recognized as the most accomplished hitter of all time.

Babe Ruth and Trend Following

When we analyze a particular investment or strategy we look at a number of different factors, but two of the most important considerations are the probability of success (how confident are we that it will work) and the risk/reward profile (what’s the potential upside in comparison to the potential downside). Gauging the probability of success is akin to analyzing a batting average, while understanding the relationship between the magnitude of risk and reward is more akin to the slugging percentage.

One of the tools we like to use when managing risk for our clients is trend following. Trend following is an example of an investment strategy that has a high slugging percentage but a below average batting average. A recent study from Ned Davis (founder of Ned Davis Research) said this about trend following strategies:

“The tape is surely not the best indicator I could put together, but it has one critical redeeming factor. If there is a big move, either up or down, one is pretty much guaranteed not to be on the wrong side for long. Trend-following allows one to let profits run and cut losses short, and that is a key to successful money management.”

In that same report Ned Davis lays out the historical results of the NDR Supply/Demand Indicator, one of NDR’s numerous trend-following models. Consider the following historical results dating back to 1998:

  • Only 14 out of 53 historical trade signals were profitable (batting average of only 26%!)
  • Average gain on profitable trades was 8.2 times larger than the average loss on losing trades
  • Annualized return of indicator was 7.2% versus 1.4% for buy-and-hold

Even though only one out of every four trades for this model was profitable, the losing trades were cut short while the winners were allowed to run. Thus, the magnitude of the average gain relative to the magnitude of the average loss led to a successful end result.

How we implement trend-following

We utilize a variety of trend-following indicators inside MarketVANE, our proprietary downside protection program. MarketVANE is designed to identify and align with the intermediate and long-term trends in stock and commodity markets. Rather than trying to trade every zig and zag or perfectly time tops and bottoms, our intention is to capture the majority of the upside during bull markets while sidestepping the significant market crashes that occur once or twice a decade on average. In other words we want to let the winners run and cut the losses short, and it’s important to understand that a “home run” for us comes in the form of successfully protecting capital in a down market – not swinging for the fences with a high flying stock. The graphic below illustrates this on a basic level.

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While we use fundamental and economic data as inputs in MarketVANE, trend-following indicators are also a crucial element in this process and play a key role in the model.

We like trend-following as an investment strategy for the same reasons we like Babe Ruth as a hitter. We don’t have to be right with every trade, but we do want to maximize the magnitude of our wins relative to our losses over time. We fully expect to live through trendless periods in the market where this approach gets whipsawed back and forth, but over a long enough period of time we anticipate being able to produce superior risk-adjusted results for our clients by successfully aligning ourselves with dominant trends.

Contributor: David Houle,CFA

Season Investments, LLC
info@seasoninvestments.com
(p) 719.528.8400
(f) 719.352.3617

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Transparency is one of the defining characteristics of our firm. As such, it is our goal to communicate with our clients frequently and in a straightforward way about what we are doing in their portfolios and why. Regular Macro Updates will address our economic and capital market viewpoints and discuss top-down portfolio positioning. Also watch for Micro Updates which convey our reasoning behind specific investments. Lastly, we do a series of Q&A posts based off questions we receive which can benefit our broad investment community.