July 17, 2013 Admin | July 17, 2013 Many individuals and institutional investors chase alpha foolishly. What is alpha and why is it foolish?
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I believe the alpha to which you refer is a reference to Jensen’s Alpha. This is a measure of abnormal/excess returns.
There are a couple theories that suggest chasing this excess return is pointless.
The first is the basic risk-return trade-off. In this, if an investor is receiving higher-than-expected returns, it is likely they are taking on more risk than they are aware.
Another set of theories that suggest chasing alpha is not worth while are those of market efficiencies. While it is believed our market is semi-strong efficient, private information holders may have an advantage in the investment realm. For others of us, the semi-strong efficient nature of the market suggests that we cannot regularly/continually earn excess returns over the market using public information or historical information.
There are other theories, more specifically those that are statistical in nature, that refute the idea of chasing excess returns when investing.
Well said, Cody. The research provides us the answer on this topic. Empirical data tells us that reaching for alpha (finding ways to increase your return on investment beyond the market return) is a loser’s game. Yes, it can happen, but you have no idea who that will be from year to year. When investing, stick with those boring no-load index mutual funds that you can find at a place like Vanguard. Not so sure? Let’s see what these wise people have to say on the topic.
Invest in low-turnover, passively managed index funds and stay away from profit-driven investment management organizations. The mutual fund industry is a colossal failure resulting from its systematic exploitation of individual investors as funds extract enormous sums from investors in exchange for providing a shocking disserve. Excessive management fees take their toll, and manager profits dominate fiduciary responsibility. – David Swensen, chief investment officer of Yale University
Investors, both individual and institutional, and particularly 401K plans, would be far better served by investing in passive or passively managed funds than in trying to pick more expensive active managers who purport to be able to beat the markets. – Professor Edward S. O’Neal, Ph.D., after completing a study in which he found only 2% of actively managed funds beat the market over a 10-year period
Most individual investors would be better off in an index mutual fund. – Peter Lynch, former manager of the ultra successful Magellan Fund
Santa Claus and the Easter Bunny should take a few pointers from the mutual-fund industry and its fund managers. All three are trying to pull off elaborate hoaxes. But while Santa and the bunny suffer the derision of eight-year-olds everywhere, actively managed stock funds still have an ardent following among otherwise clear-thinking adults. The continued loyalty amazes me. Reams of statistics prove that most of the fund industry’s stock pickers fail to beat the market. Over the 10 years through 2001, U.S. stock funds returned 12.4% a year, vs. 12.9% for the Standard & Poor’s 500 stock index. – Jonathon Clements, “Only Fools Fall in …Managed Funds?” Wall Street Journal, September 15, 2002
There are two kinds of investors, be they large or small: Those who don’t know where the market is headed, and those who don’t know that they don’t know. Then again, there is a third type of investor, the investment professional, who indeed knows that he or she doesn’t know, but whose livelihood depends upon appearing to know. – William Bernstein, The Intelligent Asset Allocator
Index funds have regularly produced rates of return exceeding those of active managers by close to 2 percentage points. Active management as a whole cannot achieve gross returns exceeding the market as a whole and therefore they must, on average, underperform the indexes by the amount of these expenses and transaction costs disadvantages. – Burton G. Malkiel, A Random Walk Down Wall Street
The investment business is a giant scam. Most people think they can find managers who can outperform, but most people are wrong. I will say that 85 to 90 percent of managers fail to match their benchmarks. Because managers have fees and incur transaction costs, you know that in the aggregate they are deleting value. You want to keep your fees low. That means avoiding the most hyped but expensive funds, in favor of low-cost index funds. Investors should simply have index funds to keep their fees low and their taxes down. No doubt about it. – Jack R. Meyer, former president of Harvard Management Company
Most investors, both institutional and individual, will find the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals. – Warren Buffett, Berkshire Hathaway chairman 1996 Shareholder Letter
Even as Wall Street belittles your investment abilities, it also wants you to believe you can beat the stock-market averages. This, of course, is contradictory. But it is also entirely self-serving. The more you trade and the more you invest with active money managers, the more money the Street makes. Increasingly, some of the market’s savviest investors have turned their back on this claptrap. They have given up on active managers who pursue market-beating returns and instead have bought market-tracking index funds. But Wall Street doesn’t want you to buy index funds, because they aren’t a particularly profitable product for the Street. Instead, Wall Street wants you to keep shooting for market-beating returns. That is why you should be suspicious when you hear talk of the supposed “stock picker’s market.” – Jonathan Clements, You’ve Lost It, Now What?
If there are 10,000 people looking at the stocks and trying to pick winners, one in 10,000 is going to score, by chance alone, a great coup, and that’s all that’s going on. It’s a game, it’s a chance operation, and people think they are doing something purposeful… but they’re really not. – Merton Miller, Nobel Laureate in Economics
The single greatest threat to your financial well being is the hyperactive broker or advisor. The second greatest threat to your financial well-being is the false belief that you can trade on your own, online or otherwise, and attempt to beat the markets by engaging in stock picking or market time. Finally, the third greatest threat to your financial well being is paying attention to much of the financial media, which is often engaged in nothing more than “financial pornography”. This conduct generates ad revenues for them and losses for investors who rely on the misinformation that is their daily grist. – Daniel R. Solin, The Smartest Investment Book You’ll Ever Read