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Aim for safe hits on the stock market

As the baseball season is about to be launched, it seems appropriate to draw a parallel between home runs and our desire to make money quickly with the next high-return investment.

Last year, Khris Davis, star player for the Major League Baseball (MLB) team the Oakland Athletics, led the MLB by racking up 48 home runs. As a reward, the team’s management offered him a new one-year contract for US$16.5 million. Davis is clearly worth his weight in gold despite a success rate of just 24.7% (the equivalent of a batting average of 0.247). In other words, he hits the ball an average of one out of every four times he’s at bat.

Of course, a home run is spectacular event in baseball. With just one play, a player can earn their team at least one point. Many active traders use this concept as a basis for managing their portfolio. They hope to make exceptional returns with just one or a handful of investments. Unfortunately, this type of strategy isn’t profitable in the long term. For example, it can be tempting to buy stocks that are trading at less than one dollar, under the pretext of getting a deal and using the stocks as leverage. These are often securities in promising, trendy industries, such as biotech, artificial intelligence and lithium. However, much of the time, they have an unfavourable risk/return ratio. Crest Advisors analyzed the behaviour of 5,000 stocks priced at below $5 from 1992 to 2003, and when a particular stock price fell to below $1, it had an 82% risk of staying there permanently.

Unlike Khris Davis, whose salary is guaranteed regardless of his performance, you are better off adopting a more conservative approach. Rather than actively seeking out the next "home run,” I recommend focusing on “safe hits,” i.e., paying close attention to the likelihood of gains and the potential for losses in your portfolio. A good starting point for achieving this is creating a balanced portfolio made up of stocks and bonds that are in line with your return objectives and risk tolerance.

Below are the results of an analysis conducted by stock market blogger Ben Carlson. He studied the performance of a 60/40 portfolio (60% S&P 500 stocks and 40% 5-year U.S. Treasuries) between 1926 and 2018.

Investment horizon Probability of a positive return Probability of a negative return
1 year 80% 20%
5 years 95% 5%
10 years 100% 0%
20 years 100% 0%
Best total return recorded over 10 years Worst total return recorded over 10 years
363.4% 0.4%
351.7% 4.6%
347.9% 8.9%
345.4% 12.1%
344.4% 12.3%

*The total return is based on a rolling average for the previous 12 months.

Source: Ben Carlson. Diversification is (Almost) Undefeated - A Wealth of Common Sense, January 15, 2019.

In light of these statistics, a simple strategy such as holding a balanced portfolio for at least 10 years can provide you with “safe hits” and earn you a positive return. To ensure that you don’t strike out, you’re better off being cautious than swinging at everything!

Sources
  • Ben Carlson, Diversification is (Almost) Undefeated, A Wealth of Common Sense, 15 janvier 2019.
  • Leigh Gallagher, Avoiding The Pitfalls Of Orphan Stocks,Forbes, April 24, 2003

The author

Michel Villa

Michel Villa

Speaker, stock market blogger and trading coach