Jun

19

How can we compare the relative importance of stock selection and market timing?

The removal from a portfolio of the best or worst performing stock(s) gives some idea of the importance of stock selection.  The removal from a stock market index time series of excellent or dismal time periods gives an illustration of market timing.

The chart below plots mean return for successive deletion of extreme winners and losers, both for skipping extreme winner and loser stocks in the stock portfolio as well as extreme gain and loss months in QQQ monthly time-series. Both series were scaled to start at zero origin, and the much larger dispersion of returns in stocks over the index is seen.

Green and yellow are the effects on mean QQQ return for skipping extreme winning and losing months. The effect is quite symmetrical in penalizing missing top gaining months and rewarding skipping bottom loser months.

Red and blue are the effects on mean stock portfolio returns for skipping extreme winning and losing stocks. The effect is asymmetrical, penalizing missing top gaining stocks more than rewarding deletion of bottom losing months.

One interpretation is that skew is more significant for stock returns within a portfolio than index returns within a period, and there is more penalty missing big individual gaining stocks within a period than missing index gains within a period.


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  1. david on June 19, 2011 11:38 pm

    Burton Malkiel of Princeton says true news is unpredictable and is thus random. Markets will react without delay thus market are really quite efficient in reflecting new information. Neither individuals nor professional can predict the market direction, patterns identified by TA are not real, rather they are typical of random series and that individuals should have their core holdings in low cost index funds….

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