The passing of Pete Rose this year brought to mind the discussion of batting average versus slugging percentage for stock selection and portfolio management. Pete Rose had a lifetime batting average of .303 with 4,256 hits in his 24-year baseball career. This means he got a hit almost once in every three at-bats, which is an outstanding result but doesn’t get him into the top ten all-time for Major League Baseball. According to MLB, Josh Gibson holds the record for the highest career batting average at .372.
On the other hand, Babe Ruth has the all-time highest slugging percentage at .6897, with a batting average of .342. The slugging percentage measures the total number of bases a player gets per at-bat, so it considers the player’s power rather than counting all hits the same as with the batting average. Interestingly, Babe Ruth also failed a lot, striking out 14.4% of the time he was at the plate. Pete Rose, by contrast, had a very low strikeout percentage of 8.1%.
So, what does all this have to do with picking stocks and managing stock portfolios?
Despite having a Babe Ruth-like slugging percentage, the U.S. stock market has a high strikeout average. According to a fascinating paper by Hendrik Bessembinder recently examining the returns on 29,078 U.S. stocks from 1926 through 2023, over half of all stocks, 51.6% to be precise, had negative cumulative returns. How does the stock market have long-term nominal and after-inflation returns higher than any other asset class while more than half of the stocks fall in value while publicly traded?
The complex mathematical answer is that stock returns have strong positive skewness. However, a simple example of long-term positive compound returns provides an easier-to-digest answer. Take a portfolio of just two stocks selling for $100 per share. The first stock grows at 9.8% annualized, while the second stock falls by 9.8% annualized over thirty years. One would think our total portfolio would stagnate during that period since the losses in one stock would offset the other, but compound returns make our intuition incorrect. The exponential return on our positively performing company outweighs the loser. This portfolio grew to be worth $1,657, a 7.3% annualized rate. In other words, the highest-performing stocks more than compensate for the losers over time.
Pick your player: Pete Rose or Babe Ruth?
All other things being equal, you would pick Babe Ruth for your team since his power more than made up in production for the strikeout. Frankly, you would want both on your team if you could. But should investors seek a high batting average or swing for the fences? In his book More Than You Know, Michael Mauboussin provides a robust rationale that one should also strive to be the Babe Ruth of investors.
He notes that “the frequency of correctness does not matter; it is the magnitude of the correctness that matters.” The dollar change in a portfolio counts as success in investing, not the percentage of stocks with a positive outcome. Much like the stock market as a whole, a successful investment portfolio typically has exceptional stocks that more than overcome the subpar returns of the duds.
Crucial Implications For Investors
Mauboussin notes that investors must consider probabilities when investing in a stock since we know that significant losses and winners in a few stocks are the likely drivers of success versus failure in investment excellence. He quotes the late, great Charlie Munger speaking about the thought process of Berkshire Hathaway’s (BRK/A, BRK/B) Warren Buffett, “Take the probability of the loss times the amount of possible loss from the probability of gain times the amount of possible gain. That is what we are trying to do. It’s imperfect, but that’s what it is all about.”
Trying to hit home runs does not mean buying the riskiest stocks. Contrary to academic teaching on the subject, riskier stocks, as defined by higher volatility, do not provide investors with higher returns. Furthermore, a few lethal losses can destroy the performance of a portfolio. While Buffett began his investing career buying “cigar butts,” low-quality but cheap companies with one more “puff” left in them, he evolved to focus on higher-quality companies with Munger’s influence. Buffett now says that “it’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
According to Howard Marks, Warren Buffett, the greatest investor of all time, is credited with just twelve sensational winners in his career. Charlie Munger told Marks that the “vast majority of his own wealth came not from twelve winners, but only four. The key was to find and hold onto those winners while avoiding significant losses. Alas, in the words of Warren Buffett, “investing is simple, but not easy.”
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