Equity Valuation and Portfolio Management

PROFITING FROM COMPLEXITY

H. L. Mencken is supposed to have noted, “For every complex problem, there is a simple solution, and it is almost always wrong.” Complex problems more often than not require complex solutions.

A complex approach to stock selection, portfolio construction, and performance evaluation is needed to capture the complexities of the stock market. Such an approach combines the breadth of coverage and the depth of analysis needed to maximize investment opportunity and potential reward.

Grinold presents a formula that identifies the relationships between the depth and breadth of investment insights and investment performance:¹⁰

IR is the manager's information ratio, a measure of the success of the investment process. IR equals annualized excess return over annualized residual risk (e.g., 2% excess return with 4% tracking error provides 0.5 IR). IC, the information coefficient, or correlation between predicted and actual security returns, measures the goodness of the manager's insights, or the manager's skill. BR is the breadth of the strategy, measurable as the number of independent insights upon which investment decisions are made.

One can increase IR by increasing IC or BR. Increasing IC means coming up with some means of improving predictive accuracy. Increasing BR means coming up with more “investable” insights. A casino analogy may be apt even if it is anathema ...