What Is Batting Average?
The term batting average refers to a statistical technique used to measure an investment manager's ability to meet or beat an index. The higher the batting average, the better. The highest number possible average would be 100% while the lowest is 0%. The term comes from baseball where players are ranked by batting average among other statistics.
- Batting average is a statistical method that measures an investment manager's ability to meet or beat the returns of a benchmark index.
- Successful investment managers need to achieve a minimum threshold batting average of 50%.
- The batting average is a big component of the information coefficient, which evaluates a manager's predictions compared to actual results.
- The information ratio is a similar measure of a money manager's success that measures portfolio returns beyond the returns of the benchmark compared to the volatility of those returns.
- One disadvantage of relying on batting average is that it focuses only on returns and does not take into consideration the level of risk taken by a manager to achieve those returns.
Understanding the Batting Average
The term batting average originates from baseball. A player's batting average represents the percentage of their hits while at bat. In finance, an investment manager's batting average refers to a statistical measure of their performance whether they outperform or underperform the benchmark.
While a season batting average of 0.300 (30%) or higher is considered an excellent achievement in baseball, the same cannot be said for investing. A batting average of 50% is used as a minimum threshold for measuring investment success.
An investment manager who outperforms the market in 15 out of a possible 30 days would have a statistical batting average of 50%. The longer the period taken in the sample size, the more statistically significant the measure becomes. Many analysts use this simple calculation in their broader assessments of individual investment managers.
Manager batting averages can be calculated by dividing the number of days, months, or quarters in which the manager beats or matches the index by the total number of days, months, or quarters in the period of question and multiplying that factor by 100. A batting average of 100% means the manager outperforms the benchmark during every single period. Conversely, a batting average of 0% means the manager never once outperformed their benchmark.
There are other baseball references that made their way into the world of investing over time. In his book, One Up on Wall Street, legendary fund manager Peter Lynch introduced the term tenbagger, which refers to an investment that returns ten times its original purchase price or has the potential to do so. An avid baseball fan, Lynch came up with the phrase because the word bag is baseball slang for a base. To score a tenbagger is like hitting two home runs and a double, or the investing equivalent of racking up a very impressive gain.
Famed investor Warren Buffet is fond of using baseball analogies when talking about investing and cautions investors not to swing at every pitch (or investment). Instead, he urges investors to focus on investing within their circle of competence, a concept he first described in his 1996 shareholder letter.
Batting Average vs. Information Coefficient (IC)
The batting average is a major component of another key metric: the information coefficient (IC). This is a statistical measure that is used to evaluate an investment or portfolio manager's forecasts with their actual results. This is typically done with predicted and actual stock results.
This metric is calculated using the following formula:
IC = (2 x Proportion Correct) - 1
Proportion Correct represents the proportion of correct predictions made by the manager
As such, a professional's information coefficient can range from 1.0 to -1.0. An IC of -1 means that the forecasts don't match an individual's financial results while an IC of 1 means both are perfectly matched.
Batting Average vs. Information Ratio (IR)
The information ratio (IR) is a similar measure of the performance of money managers. The IR measures portfolio returns beyond the returns of the benchmark compared to the volatility of those returns. The IR not only measures the investment manager's ability to generate high returns relative to the benchmark, but it also endeavors to identify the manager's performance consistency.
The calculation includes a tracking error that shows how consistently the manager can achieve portfolio returns that track the index. A low tracking error means the manager consistently beats the index performance, while a high tracking error signals the manager's returns are more volatile and not consistently beating the benchmark.
However, the IR does not easily string together a series of successes or failures, which are helpful when assessing final investment outcomes. The batting average overcomes this shortcoming by answering: Does an investment manager win or lose most investment bets?
The information ratio and the batting average are two commonly quoted measures of investment success, but these measures have shortcomings. The IR contains no information about higher moments, and the batting average contains only directional information.
Limitations of Batting Average
An investment manager's batting average suffers from two primary limitations. First, the batting average focuses only on returns and does not take into consideration the level of risk taken by a manager in achieving returns.
Second, the batting average does not factor in the scale of any potential outperformance. A manager may outperform the benchmark by, say, 0.1% for 10 months, but in the 11th month fall short of the benchmark by 3.50%. In such a case the batting average would be 90.90%, but the manager would have dramatically underperformed their benchmark.