I was having a conversation yesterday with a friend in the finance world about achieving alpha. For those unfamiliar, alpha is a term in finance that describes outperforming the markets. I always get a kick out of telling the story of the monkey who was able to beat 2 of 3 Wall Street professional investors through picking stocks by throwing darts. If you haven’t heard this story, its true. In fact, its been tried numerous times by different people experimenting on the idea of stock-picking. The truth is, in a majority of cases, a monkey was able to invest more successfully in individual stocks than investment professionals who were doing in-depth analysis on companies. The kicker to the experiment is that when performed, usually the investors only get to allocate money to a handful of stocks, as opposed to designing a full portfolio.
The lesson to be learned with the experiment is that ‘picking stocks’ is hard. Since a monkey can do it better than investment professionals, its a fool’s errand. But when it comes to achieving alpha on a portfolio, that is a different story. Achieving alpha is still extremely difficult, even if you’re trying to achieve it with a highly diversified portfolio. An entire hedge fund industry has been built for money managers to try to achieve alpha, but even a majority of these firms fail to achieve alpha on a consistent basis.
Is achieving alpha even worth the effort?
Well for individual investors, not at all. The S&P 500 dating back 100 years has returned 11.7% on an annual basis. If you take into account compounded interest, here is what your return would be if you started buying an Index Fund at age 30, investing $100 per week:
Here’s what you would have if you bumped your investing rate to $200 per week:
Lastly, let’s assume the annual return on the S&P 500 is only 9% over the next 30 years as opposed to 11.7%, which would be much lower on average:
Either way, you would end up with a huge nest egg at the end of your working life. Also notice I only set the investment calculator to go to age 60. When it comes to investing, your contribution amounts are much more important than your rate-of-return, and the age at which you start investing is much more important than both of those factors. So why even try and achieve alpha by outperforming the market as an individual investor? It’s not worth the time and effort, and the risk required to achieve alpha is not worth it either.
That is why volatility in markets and times of uncertainty for the economy should lead investors to stick with the basics. Owning an Index Fund allows you to bet on the economy and innovation over a long-time horizon. In other words, shorten-up your swing. When the market is facing complex circumstances, the best thing you can do is to simplify everything. If you’re contributing to an Index Fund or buying stocks, just look for simple reasons when you are forming your investment thesis. And most certainly, do not feel the need to be more active in your portfolio as a means of ‘fixing your investments for the current market environment.’ Sometimes less is more, and the best thing you can do is to not panic into making decisions out of fear or greed.
For money managers, its a completely different ball game. We are being paid by individual investors to find an edge. Now, managing money on behalf of clients is not all about outperforming the market, or even based solely on generating healthy returns. A lot of people do well financially, but don’t understand much or anything about the investment world. I’d be willing to bet at least 8 of every 10 middle-class people don’t know what an Index Fund is, or even have the slightest idea of where to start in investing for their futures (and I’m low-balling that guesstimate). It is also far more important for money managers to properly manage risk.
For those of us competitive enough to seek alpha, or who work in financial services and have clients who want to achieve alpha, it is most easily accomplished in bear markets. To me, trying to figure out how to position a portfolio to outperform in a year when the S&P 500 is already returning 20% to investors is almost impossible. That is why most hedge funds have not been able to generate alpha in the better part of the last decade. However, with turmoil in the markets, the past year has been a different story for those seeking alpha.
By the way, outperforming the S&P 500 Index is such a difficult task because over time, the S&P 500 self-corrects. Meaning, if some stocks see declines in their businesses, and others see increases in profitability, the declining stocks become a smaller percentage of the S&P, and the better businesses become a higher percentage. That is why Apple has grown to be 7% of the entire S&P 500. The S&P 500 also kicks out businesses from the Index that become unprofitable over time as consumer behavior and industry formation shifts. But as long as greed remains a main behavior among human beings, and as long as highly competitive people look to win against competition, there will always be a demand for achieving alpha.
One of the ways in which active managers can try to generate alpha is by running a long-short portfolio. This is a portfolio that invests in stocks a manager sees as suitable investments, but always bets against stocks that may be out of favor for any number of reasons.
An example of how an active manager may set a long-short portfolio may be the following:
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