Why would a skilled stock picker ever invest in more than a few of her best ideas? Isn’t diversification for those who don’t know what they are doing? It makes sense to think that a skilled stock picker with limited resources will not be able to generate similar alpha with her 50 best ideas compared …
How much skill a concentrated stock picker needs to beat a diversified benchmark? Read More »
Long-term investors measure growth rate, but eat compound wealth. The four determinants of terminal wealth ratio (randomly selected portfolio’s terminal wealth divided by benchmark terminal wealth) and probability of losing to fully diversified benchmark will be introduced and analyzed: Idiosyncratic variance of a single stock (idiosyncratic variance of the selected investing style), time horizon length, …
Compounding materializes the importance of diversification Read More »
We will show that the single best metric predicting drawdown risk is portfolio volatility normalized (divided) by Sharpe ratio i.e. fraction of full Kelly allocation. We first derive the formulas for drawdown probabilities and expected drawdowns, then verify the formulas by simulations and finally demonstrate with empirical data. With the exception of the effect of …
Drawdown risk = portfolio volatility normalized by Sharpe ratio Read More »
We will see how the diversification assessment framework provided by conventional finance theory is not applicable to what long-term investors really care about – compounded returns. As long-term investors care about geometric (instead of arithmetic) expected return, we will find that diversifiable risk is not only uncompensated but costly. As a consequence, diversification is not …
Expected return is at the center of financial analysis. But when you hear expected return, you can’t be sure if it is geometric expectation (time average) or arithmetic expectation (ensemble average). Almost without exception, investors mentioning expected return mean geometric expected return. One reason is that realized historical returns are geometric. But more importantly, long-term …
The Kelly criterion, capital market parabola & the almighty Sharpe ratio Read More »