Winners, losers, plodders and skewed returns

Share returns are skewed to the right. This means that you can only lose 100% on your investment in a company, but winners can theoretically be unlimited, dragging portfolio returns up above the median.

How do you exploit this simple mathematical fact?

The first and most important thing is to have a well-diversified portfolio with at least 25 stocks but preferably no more than 50. Nobody knows which firms are going to become highly successful so the only sensible and logical thing you can do is to have enough potential winners included in your portfolio to increase your chances of owning a “bolter”.

Say for example you wanted to invest in solar energy. The safest way is to research the industry and find the five stocks that seem to have the most likelihood of being very successful. In reality one may go broke, one halves, another may stay pretty much the same price wise, the fourth doubles in price and the fifth goes up five-fold. With $2000 dollars in each you have lost $3000 on the first two, made nothing on the third, made $2000 on the fourth and $8,000 on the fifth. A total gain of $7000 dollars or a 70% increase.

It was only the inclusion of this one share, out of five, that made you most of the money. This example of returns being skewed to the right shows that if you miss out on these companies that have the potential to increase many times in value, that can be more dangerous than the stock that goes to zero and loses 100% of its value.

To adopt this theory, you have to exclude those companies that could be described as plodders, the companies that are unlikely to go broke but will not do anything amazing, big blue-chip companies, the Telstra’s, the big banks, the AMP’s of the stock market.

They are not the most or least desirable type of stock to own but owing to their sheer size are very unlikely to be able to appreciate by a large percentage and be that last, very profitable share that makes all the difference

Of course, to do this you need a well-diversified portfolio and patience to exploit this simple mathematical truth.