Almost every investor aspires to outperform the market and peers by a significant margin. When asked how they plan to achieve this, they often vaguely reference the strategy of picking big winners in the stock market, aiming at substantial returns. In theory, this approach is hard to refute — after all, selecting large winners should, all else being equal, set one’s portfolio apart from the market.

However, as the famous baseball player Yogi Berra once said, “In theory, there is no difference between theory and practice. In practice, there is.” To uncover the limitations of aggressively chasing big winners, we must first examine a mathematical phenomenon that challenges this strategy

Coin toss

Let us view the example of Professor Ole Peter’s simple coin toss. Suppose once you flip a coin and if it is heads you gain 50% more or if it is tails you lose 40%. If you started with ₹100, most of us would take the bet because it seems favourably skewed.

We assume that if we take the bet enough times, we will turn a tidy profit for the day. However, the key distinction here is that if you were to take the bet suppose 100 times, the expected value of your net worth would be close to ₹0.

The reason is if you were to win the first toss and gain ₹50 and lose the second toss, your net worth would already be at ₹90, and suppose you were to lose the first toss and win the second toss, your net worth would be at ₹90 as well. If you repeated this game for 10 tosses and won five of them and lost five of them, your expected net worth would be ₹59.

Losing more

Therefore, the more bets you take as you will be expected to have an equal number of heads and tails, you will stand to lose much more than you gain. The reason is that if you were to lose 40% of your principal, it would take roughly a 67% increase to make back the losses and become whole. If 10 individuals took this gamble at the same time once, a large portion of them would have positive results.

However, it is guaranteed as they progress, all of them will finally end up with negative returns. Similarly, when in the markets when an investor decides to opt for a high-risk, high-reward strategy, they inherently undertake such a gamble where they have heavy downside risk while trying to chase large winners.

In some cases, this pays off, with those investors raking in large gains and outperforming the market exceptionally as evidenced by those who rode the AI stock boom in the U.S. Another way in which the bet morphs into high risk and high reward involves the use of leverage in their portfolios.

Disastrous leverage

When an investor takes multiple bets in this same fashion in the stock market, one bad coin toss, or in our case stock pick (sometimes with leverage involved) ends up with disastrous losses leading them to never be able to recoup their losses.

These individuals end up underperforming even those who had parked their investments in risk-free assets such as treasury bills. An example of how things can go wrong is the 2000s dot-com bubble, which corrected by 75%.

It took 15 years for those who bought the NASDAQ during the peak of the bubble to recoup their losses. Their portfolios would have had to go up by 300% from the bottom-most point for them to have been made whole.

Bugger risks

Additionally, those who seek to recoup their losses typically continue to take on larger and more aggressive bets with even greater downside risks. Taking on greater risk only magnifies the phenomenon creating an accelerated cycle to financial ruin.

Value investing

In contrast, value investing prioritises controlling downside risk over chasing upside gains. As the renowned investor Warren Buffett wisely advised, “The first rule of investing is to not lose money, and rule number two is to never forget rule number one.”

By avoiding catastrophic losses during downturns, you position yourself for long-term outperformance, outlasting those who fail to account for downside risk. Investing in companies trading well below their intrinsic value, with low price-to-earnings ratios and minimal debt, offers a safer route to outperform in the long run, compared to the volatile nature of market favourites that can swiftly fall out of favour.

(Anand Srinivasan is a consultant. Sashwath Swaminathan is a research assistant at Aionion Investment Services.)

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