The Power of Payoff

Payoff: The investment skill metric that separates the best investors from the rest.

By Clare Flynn Levy

One of the most memorable days of my career as a fund manager was the moment I realized that although I was picking a lot of winners, they were consistently adding less value than my losers were destroying. One of my investors, who was way ahead of his time on all things data-analytics, took a look at my track record and offered a new perspective that made it very clear. It was a rude awakening: from a “return on energy expended” perspective, I was totally wasting my time.

What I didn’t know then was that the metric he was focused on was payoff — and payoff is ultimately what separates the best investors from all the rest.

We often hear fund managers say “I only need to get it right slightly more than 50% of the time.” What they are referring to is hit rate (or batting average, to the Americans among us). Hit rate looks at what percentage of decisions make money — in absolute or relative terms. And yes, the ideal is to achieve a hit rate on decision making that is higher than 50% — whether you are a fund manager or a regular person in everyday life, right?

Yet the fact is that most fund managers have a hit rate on their overall decision-making of less than 50%. Our recent study, The Behavioral Alpha Benchmark, found that only 18% of portfolio managers make more value-additive decisions than value-destroying ones.¹

But guess what: While hit rate garners a lot of attention, it is often less consequential than payoff. A good payoff ratio can more than compensate for a sub-50% hit rate — and a poor payoff ratio can completely nullify the effect of a strong hit rate.

Here’s why. Payoff is the:

Payoff is expressed as a percentage: over 100% is good, under 100% is bad. If you’re a baseball fan, payoff is conceptually similar to slugging percentage (i.e., how powerful are your hits?), but it’s not quite the same thing: in investing, your failed at-bats can actually generate negative points.

Payoff measures whether your good decisions have typically made you more than your bad decisions have lost.

He didn’t use the term, but payoff was a key theme expressed by the legendary Peter Lynch, who in 1990 told Wall Street Week’s Louis Rukeyser that “you only need one or two good stocks a decade.” Those would need to be VERY good stocks, of course, but the point is that payoff — making sure your winners win, on average, more than your losers lose — is one of the most critical factors in successful professional investing.

Perhaps it’s ironic, then, that asset owners and allocators — who ask for a wide variety of statistics from managers in an effort to separate luck from skill — tend to overlook payoff. When, in fact, it’s one of the purest skill metrics we have. A manager who consistently achieves a payoff over 100% is exhibiting true investment skill: knowing when to hold ‘em, and when to fold ‘em.

Whereas retail investors commonly exhibit the disposition effect (cutting winners too early and running losers too long), professional fund managers typically only exhibit half of that behavior: they are good at running winners, but they struggle like everyone else when it comes to knowing when to cut bait.

The ability to cut losers — and, indeed, to cut winners before they become losers (as evidenced in our peer-reviewed research paper called The Alpha Lifecycle) — is what the best investors are good at. And that manifests in a high payoff.

The image above comes from our recent Behavioral Alpha Benchmark study. It looks at all of the trading decisions made by 76 active equity portfolios over the last three years and plots their hit rate against their payoff. The dotted line represents what would be achieved by chance: you’re correct half the time (a 50% hit rate) and your average winner makes exactly as much as your average loser loses (a 100% payoff).

While you can see that managers’ hit rates exist in a pretty tight band (the X axis), their payoffs vary dramatically (the Y axis). The top five managers (colored in magenta) have both high hit rates and high payoffs.

This diagram — and its use of payoff as a key comparative metric for portfolio managers — represents an important next step in the evolution of manager assessment methodology. It enables us to look beyond traditional evaluative metrics based on past performance — which are highly subject to the random effects of luck, and thus limited in their utility — and focus instead on the quality of a manager’s decision-making, a far more accurate assessment of his or her skill.