Picking Winners (by Jim Parker Dimensional FA)

Anyone who sweats over the Melbourne Cup form guide each year might find themselves reflecting on the similarities between trying to select a winning horse and finding investment success by picking individual stocks.

In Australia’s premier horse race, there are so many variables for the punters – weights, age, barrier draws, recent form, the race distance, the weather and the state of the track.

If you’re trying to pick stocks, the options are just as bewildering. You can look at fundamentals such as earnings growth or momentum, price-earnings ratios, cash flow, return on equity, margins, or the stock’s record of earnings surprises. And this is by far from an exhaustive list.

For racing punters or stock pickers, there are also qualitative factors to consider. On the track, gamblers can look at the record of the trainer, the expertise of the jockey, or the bloodline and temperament of the horse.

On the stock market, stock pickers can take into account issues like industry fundamentals, management’s track record, the relative quality of the firm’s product or service and its ability to innovate and deal with change. Again, this is only a handful of dozens of variables.

Of course, if all this is too hard, you can always seek outside help. For the investor, there are broker recommendations. For the punter, there is advice from tipsters, bookmakers, journalists and the ranks of self-appointed experts.

And there is always plenty of advice. So in the Melbourne Cup in 2020, for instance, you could have taken direction from some confident sounding calls.

On the day of the race, one racing editor described the Caulfield Cup-winning ‘Verry Eleegant” as the nation’s premier horse. Its trainer Chris Waller had won just about every big race on the calendar, with the Melbourne Cup the only to elude him to date. So the stars were aligned.

The first and second favourites for the big race were Irish pair ‘Anthony Van Dyck’ (an English derby winner) and ‘Tiger Moth’, with two wins and two placings in its four career starts.

As it turned out, however, the little fancied ‘Twilight Payment’, another Irish horse, overcame middling recent form and an underwhelming write-up by the tipsters to win the gruelling 3,200-metre race at odds of 26 to one.

Tragically, pre-race favourite ‘Anthony Van Dyck’ broke down with a leg injury and had to be euthanised. ‘Tiger Moth’ came second, while ‘Verry Eleegant’ was seventh. After the race, ‘Twilight Payment’s victory was depicted in the media as quite logical. It was, after all, owned by a multiple-winner of the Melbourne Cup in Lloyd Williams.

So why wasn’t this all self-evident beforehand?

For the frustrated stock picker, it’s a familiar story. Year after year, brokers line up their top tips for the coming 12 months. Some turn out to be winners. Others turn out to be losers. There is very little pattern in which calls come in. And everyone is wise after the fact.

In early 2020, one Australian news publication ran the results of a roundtable with analysts on their expectations for market sectors in the coming 12 months. The consensus was that the energy sector would be one of the top performers.1

But then along came the pandemic. Cities were locked down, people were housebound and airlines virtually stopped flying. As well, a price war broke out between major oil producers. Energy turned out to be the single worst performing sector in 2020.

The fact is there no guaranteed way of picking winning stocks, or horses. Even the most expert analysis is subject to unexpected events. Whether it is a horse breaking a leg on the racetrack, or a pandemic messing up everyone’s stock forecasts, so much of what is sold as advice is really just an intelligent guess based on past events.

Analysts who say they can outguess the market rarely do so for long. The random nature of returns means that any short-term success is invariably due more to luck than skill.

The good news is you don’t have to speculate to be a successful long-term investor. Indeed, if you start with the assumption that markets work, and structure a diversified portfolio around the known long-term sources of higher expected return, keep costs low, and stay disciplined you are much more likely to have a successful experience.

And for those who still have the gambling bug, you can always take a flutter on the horses. Just don’t take it too seriously!

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