Stockpicking -- Are You As Good As You Think?

By

G A Chester

Published in Investing on 20 September 2010

We show you how to measure your performance.

There's only one reason to invest in individual stocks: to earn a better return than you'd get by investing in the whole market. If you can't choose stocks that consistently outperform a passive index tracker, your stockpicking approach will not only be a waste of time, but will also seriously damage your wealth.

The only way to know if you're any good as a stockpicker is to measure your performance.

Unitisation

Most investors don't make a one-off, lump-sum investment. We tend to add money to our portfolios over time, whether regularly or irregularly; and, occasionally, we may withdraw money, for example, to pay a child's school fees or fund a holiday.

To get over the difficulty of measuring the performance of a portfolio that has money going in and coming out, we can adopt the principle of 'unitisation', which is used by unit trusts/OEICs.

Concrete examples are generally easier to grasp than abstract theory, so I'm going to use the Family Firms Portfolio to show you how unitisation works in practice.

The Family Firms Portfolio is being constructed over a period of time, using The Motley Fool ShareBuilder service. We are making regular investments of £150 a month.

First investment -- 7 July

The first time you put money into your portfolio, you decide on an arbitrary unit value. You then convert your initial cash injection into units.

In the case of the Family Firms Portfolio, let's say we decide our unit value is £1. As our initial investment is £150, the portfolio consists of 150 units (£150/£1).

Second investment -- 5 August

Each time we inject new money into the portfolio, we look at its value just before doing so.

Ahead of our second family firms investment the portfolio value was £178. We divide the value by the number of units to get the current unit value: in this case, £178 divided by 150 units, giving a unit value of £1.19. We then divide the new cash being injected (£150) by the unit value (£1.19) to give the number of new units being created: 126.

So our portfolio now consists of 276 units (150 + 126).

Third investment -- 7 September

We repeat the process with each new injection of cash.

Ahead of our third investment the value of the portfolio was £348. Dividing £348 by the number of units (276) gives a unit value of £1.26. Again we divide our new cash injection of £150 by the unit value -- this month £1.26 -- giving us 119 new units.

The portfolio now consists of 395 units (276 + 119).

Current value -- 17 September

We can see how the Family Firms Portfolio has performed in its short life to date.

The current value of the portfolio is £502, which, divided by the number of units (395), gives a unit value of £1.27. So, the unit value has increased 27% (£1.00 to £1.27) since we made our first investment on 7 July.

Selling

If money is permanently removed from the portfolio, we follow the same procedure, but subtract the units. So, if on 17 September we decided to take £254 out of the portfolio, we would divide that amount by the unit value of £1.27, which would tell us that £254 is the equivalent of 200 units. As we are 'subtracting' the cash from the portfolio, we subtract the units.

The portfolio now consists of 195 units (395-200) and is valued at £248 (£502-£254); and the unit value remains the same -- as it should -- at £1.27 (£248/195 units).

Simplicity

Going back and unitising an existing portfolio can be a lot of work if it was started a long time ago. But you can unitise it from today, simply by looking at the current total monetary value, assigning an arbitrary unit value, and calculating a base number of units for going forward.

It doesn't take much time to manually update a unitised portfolio -- and even less time if it's set up in a spreadsheet. Remember, the number of units only changes when new money is added or money is permanently withdrawn.

All trades within the portfolio, including the reinvestment of dividends and temporary holdings of cash, have no impact whatsoever on the number of units.

Benchmarking

Once your portfolio is unitised, you are in a position to make a like-for-like comparison of your performance with a suitable index, index tracker or actively managed fund.

In the case of the Family Firms Portfolio, our 'investment universe' is UK-listed stocks. If we weren't stockpicking the money would probably be going into a FTSE All-Share tracker, so it's appropriate to use such a tracker as our benchmark.

Also, because we are planning to reinvest dividends, it makes sense to benchmark against the 'accumulation' version of the tracker; if we were routinely taking dividends out, the 'income' version would be the choice.

We can pit our portfolio against the HSBC FTSE All-Share Index fund, for example, which is just one of a number of suitable All-Share trackers:

Unit value
at 7 Jul
Unit value
at 17 Sep
Gain/loss
Portfolio£1.00£1.27+27%
Tracker£2.84£3.23+14%

I hasten to add that this is merely an illustration of what unitisation allows you to do. A couple of months is way too short a period to draw any conclusions about a portfolio's performance.

However, if after 5 or 10 years you find you've been handsomely outperforming your benchmark, you may just be cut out for stockpicking.

Equally, if you've miserably underperformed over such a period, it may be time to start thinking about passive investment.

You won't know either way, though, unless you measure your performance. Get unitising!

More from G A Chester:

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The opinions expressed here are those of the individual writers and are not representative of The Motley Fool. If you spot any comments that are unsuitable hit the flag to alert our moderators.

20 Sep 2010 , 9:48am

Excellent, now you need to measure the risk of the portfolio.

20 Sep 2010 , 12:06pm

How does one measure the risk of the portfolio? What would one do with that information?

I am a novice investor and genuinely interested. I notice that you have commented on this theme before.

Regards,

Joe

20 Sep 2010 , 12:41pm

Although it is not ideal the industry norm is to use the tracking error.

www.investment-performance.com/forums/search.php?searchid=2006

This site will give more details.

Measuring performance with measuring risk is like sayng that is Ferrari does 170 mph and is therefore much better than a Kia Sedona. Knowing the insurance group and fuel consumption of both cars helps in making a decision about which is "best".

20 Sep 2010 , 8:43pm

"There's only one reason to invest in individual stocks: to earn a better return than you'd get by investing in the whole market."

Absolutely wrong, unless you're a pure speculator.

I choose to invest in companies I believe in. A proportion of my money goes into those I actively approve of, while the remainder goes into those on which I am neutral. Evil sectors such as tobacco, vivisection, or fossil fuels won't get my money.

That is one reason to invest in individual stocks. I could name more, but it only takes one counterexample to blow up a uniqueness assertion. Oh, and yes I believe I am well ahead of the index (I measure by the tax year, and was pleased to note a gain of over 100% in April, following a loss of just 1% over the preceding crash year).

20 Sep 2010 , 11:58pm

I believe in allowing people to choose for themselves if they smoke, providing they are not in a room shared with other people.

Having suffered from other peoples tobacco smoke in pubs & so on for years, why shouldn't I make a profit from investing in tobacco? It's kind of getting my own back. People know what the effects of smoking are, so it's perfectly OK to make a profit from this.

21 Sep 2010 , 12:01pm

As a lifelong non-smoker, I believe in allowing anyone to smoke anywhere they please, since 'passive smoking'-- like 'Islamofascist terrorism'-- is merely a scare story designed to bully people into behaviour espoused by busybodies or exploiters.

If someone chooses to kipper himself to death at 60 instead of leading a long, miserable, smokeless life and burdening me with the cost of his NHS care, well and good. And I like to sniff the smell of a fine Partega.

Smokers tell me it calms their nerves. How much nervousness, irritability and worse is being engendered by forcing them into the cold and rain, and how bad is that for the nation's tranquillity?

Long life to BATs and Imps, and an early, unforeseeable accidental demise (under the wheels of a polluting vehicle breaking fussbudget speed limits) to health fascists everywhere.

21 Sep 2010 , 2:00pm

Well, that's just wrong!
I shall illustrate why by using a simple example:
Say on 1st Jan. I invest £150 and assign a unit price of £1. I will have 150 units. Six months later, with unit price standing at £3, I invest another £150, which gives me another 50 units for a total of 200 units. Let's say at the end of the year, the portfolio is worth £320 and I sell all my units. Unit price now is £320/200 = £1.60. Unit price on 1 Jan: £1, 31 Dec: £1.60. Therefore gain=60% - Wrong!

NPV is the correct way to do this calculation, which gives you the annual rate of return of 8.95% for this example.

21 Sep 2010 , 6:28pm

Hello koochak

'Unitisation' aka Unit Valuation System (UVS) is the standard method used by Unit Trusts/OEICs to compare their performance against eachother and/or a benchmark. Individual investors can also use it, as I've described, as a comparative performance tool to see whether they are out- or under-performing a benchmark index or fund.

It's a way to measure the relative performance of a portfolio that has money going in and coming out, rather than the absolute rate of return when the portfolio is liquidated.

Foolish best
MobyD (G A Chester)

23 Sep 2010 , 9:01am

There's only one reason to invest in individual stocks: to earn a better return than you'd get by investing in the whole market.

Not always true.

The first shares I bought were in the Standard Life demutualisation. My motivation at the time was to earn a better return than I would have got from putting the money into a building society account. By using Excel to calculate the XIRR (essentially the NPV calculation mentioned by koochak) I find that the return currently equates to 10.26%pa. I've no idea how that compares with a FTSE100 tracker, but it compares favourably with a building society account so I'm happy.

It may be that the unitisation system offers a consistent basis for comparison between Unit Trusts, but perhaps koochak's example suggests it wouldn't be wise to use it for camparison with, say, the return from a building society account.

26 Sep 2010 , 11:44am

If you don't drink, don't smoke and never chase fast women, you will not live any longer - it just seems like it!
Also, buying shares with ascending prices ensures a loss when the price drops. Better to save your money until the price does drop, then invest.

29 Dec 2012 , 4:51pm

MobyDick, He is correct in that the rate of return is 8.95%. But on the other hand, if I plot my units or any share prices on a chart they would show a gain of 60%. If I had put a £1000 in on day one, and sold for £1600 on day 365, it would have been a gain of 60%. So where is the slight of hand: what does it all mean?
I don't believe anyone looking at a share price chart which had risen 60% would say "it hasn't really, you know".

Arb.

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