Virtually all professional investors focus on performance vs. a benchmark index, i.e., relative performance. One reason is that this is what clients (likely also including ourselves) expect, even though they seldom see the managers they hire achieve this goal. A second is that it’s much easier to say A is a better buy than B than to say A is flat-out good. A third is that stock markets tend to react sharply to unexpected news rather than move little by little each trading session. So, historically anyway, the worst position to be in is to have a large cash position.
Maybe the most important consequence of this approach is the shift in conceptual framework this entails. We begin to perceive and quantify risk in terms of deviations from the structure of one’s benchmark index, in the expectation that we will get a better-than-index return by doing this.
Let’s define a bad stock as one that you have either more than the index weighting in the (incorrect, as it turns out) expectation it will outperform or hold less than the index in the (again, mistaken) expectation it will be a dog. In my experience, making a mistake of the second type subtracts much more, say, 3x, than a stock that outperforms in the way your analysis predicts will add to performance. This means that identifying and eliminating mistakes is a much more important task for a portfolio than is generally realized.
For any active managers, it’s way more important to know a lot–preferably much more than the consensus–about a few stocks where you have a high degree of certainty (in the best case, that most don’t realize yet) than to know an average amount about a lot of different companies. The latter approach ends up relegating you to likely being the dumb money everywhere.
Experience will eventually tell you how much is enough to know. So to be successful you have to hold two potentially conflicting beliefs: you have the arrogance to be convinced you know more than the consensus does about each of your positions–or at least all the big ones; at the same time, you have to be humble/self-aware enough to understand that even the best pms are easily wrong 40% or so of the time. Everyone knows that you ride your winners and cut your losers. The real trick is to have failsafe measures in place to force you to do the second.
Happy Holidays!!