“No matter how good you are, you’re going to lose a third of your games. No matter how bad you are, you’re going to win a third of your games. It’s the other third part that makes the difference” — Tommy Lasorda.
This phrase, immortalized by the legendary manager of the Los Angeles Dodgers, can be analyzed from many perspectives, beyond its motivating spirit.
Looking at historical figures from 1901 to date, the MLB team with the worst record won only 23% of its games in one season, while the best team won 75%. However, the distribution of these 2,466 observations seems to have a degree of normality, and coincidentally 95.8% are between 33 and 66 percent — which stands between -2 and +2 standard deviations. Well estimated, Mr. Lasorda.
For a couple of months people have been wondering, what is going to happen in the market throughout the upcoming year? In more than one editorial, experts and market scholars that tilt towards an evidence and data driven approach, have stated the following answer. If I had to guess, I’d say it’s going to go up.
WHAT IS THIS ASSUMPTION BASED ON?
Only in the last 90 years the S&P 500, one of the most representative indices of the stock market, has shown positive annual returns on 60 occasions, that is, 66.7% of the time. Sounds familiar?
It is important to remember that it is not a rule of thumb that in every set of three years we will witness two advances and one decline. Frequently, people believe that the odds are fully met in experiments with few observations.
I invite you to flip a coin 10 times, most likely you will not get an equal distribution. The truth is that the more times that the process is repeated, the results will get closer to a 50/50 distribution. Why is this not always true? There are those who call this phenomenon the law of small numbers.
How can you guarantee having 50 percent of heads and 50 percent of tails? With more iterations — the more times the experiment is repeated — the distribution will be closer to the theory. Try flipping the coin 100, 1,000 or 10,000 times.
Returning to the stock market, knowing that historically the market has had an annual return of 7.6% — measured through the S&P 500 return — and that investors have been able to collect profits 66.7% of the time, it would be worthwhile to be invested in the market.
Yes, there is always the likelihood that the current year will be the downward year, but we have already discussed the risk associated to remain on the sidelines—measured as opportunity cost. It should also be emphasized that this is not a universal recipe, you should always take into account the profile of the investor and the investment.
Back in the ballpark
Only 14 teams in the MLB have won over 70% of their games in a season. The team with the highest winning record in a single season are the 1906 Chicago Cubs, who lost that World Series against their neighbors and rivals, the White Sox. The last team to surpass 70% were the Seattle Mariners in 2001, who also did not rise with the championship. And the last team that beat 70% and won the World Series in the same year were — sadly for a Red Sox fan — the New York Yankees, in 1998.
For the more sophisticated investor
We already saw what we could expect in the market, from an statistically approach, now how could we stand out from that normal distribution? How to differentiate or focus on the third that matters according to Mr. Lasorda?
Michael Mauboussin, in his book Success Equation (one of the Best Books I Read in 2017), talks about how success depends on a mixture of skill and luck, and according to the subject matter, the weighting will be different.
So, the answer would be with skill and effort, the traders and expert investors get up every day to overcome these results. They work in models and try to optimize them, minimize volatility, reach an ideal diversification, achieve a better control of risk in a disciplined way, and eventually beat the benchmark.