Thursday, January 11, 2007

Stock Picking vs. Market Timing

I am thrilled once again that the Forbes Growth Investor and Special Situation Survey investment newsletters outperformed the market in 2006. According to the Hulbert Financial Digest, the three portfolios in the Forbes Growth Investor had an average return of 16%. That puts it ahead of Hulbert's benchmark, the Wilshire 5000. It also places it in the top quartile of all newsletters Hulbert follows. The Special Situation Survey did even better. Hulbert shows it up 20% for 2006, well ahead of the benchmark and also in the top quartile.

Measuring performance can be tricky. To do it correctly you must consider two skills: stock-picking ability and market timing. An investment manager or newsletter editor who beats the market when the market is rising isn't necessarily a good stock picker. Any ordinary stock picker can do that in a rising market simply by employing leverage (i.e., buying stocks on margin). In order to determine if someone is truly a good stock picker, you must de-lever the returns. That is, you must compute what the returns would have been if leverage had not been used. This is the only way you can separate stock-picking ability from market-timing skill. It is also the only way you can compare the stock-picking abilities between managers who employ margin and those who don't.

Unfortunately, Hulbert doesn't de-lever returns. However, he often warns readers that some results have benefited from the use of leverage. Neither the Forbes Growth Investor nor the Special Situation Survey employ leverage. Our results are produced solely from pure stock-picking ability.