In his book – More Than You Know, Michael Mauboussin explains that in probabilistic endeavors, such as investing, the frequency of being right is less important than the magnitude of success when you’re right.
A portfolio manager, despite having a poor percentage of winning stocks, achieved strong overall results due to one big winner. This concept is called the “Babe Ruth effect,” where striking out often doesn’t matter if the successes are large enough.
Mauboussin emphasizes the importance of expected value analysis in decision-making, although human nature often struggles with this approach, as we tend to focus on consistency rather than overall outcomes.
Here’s an excerpt from the book:
This particular portfolio manager found himself in an unusual spot: while his total portfolio performance was among the best in the group, his percentage of outperforming stocks was among the worst.
The treasurer promptly fired all of the other “poor” performing managers, and called a meeting with the investor to figure out why there was such a large discrepancy between his good results and his bad batting average.
The portfolio manager’s answer is a great lesson inherent in any probabilistic exercise: the frequency of correctness does not matter; it is the magnitude of correctness that matters.
Say that you own four stocks, and that three of the stocks go down a bit but the fourth rises substantially. The portfolio will perform well even as the majority of the stocks decline.
Building a portfolio that can deliver superior performance requires that you evaluate each investment using expected value analysis. What is striking is that the leading thinkers across varied fields—including horse betting, casino gambling, and investing—all emphasize the same point.
We call it the Babe Ruth effect: even though Ruth struck out a lot, he was one of baseball’s greatest hitters.
The reason that the lesson about expected value is universal is that all probabilistic exercises have similar features. Internalizing this lesson, on the other hand, is difficult because it runs against human nature in a very fundamental way.
While it’s not hard to show the flaw in the treasurer’s logic, it’s easy to sympathize with his thinking.
You can find a copy of the book here:
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