When setting up a portfolio, it is crucial to understand the assumptions that you are comfortable making. The financial markets are extremely complex and when setting up a portfolio you have to be realistic with yourself. A plan that changes every week is not a plan. Finding assumptions that you are comfortable making allows you to find a strategy you believe in and stick with it. Here are the assumptions that my portfolio would have to be built on.
Expenses are one of the few certainties
Many academics argue that there is no “free lunch” in the capital markets. I largely agree with that, but I like to think of eliminated expenses as one the few “free lunches” out there. The financial markets are full of uncertainty but fees are one of the few certainties. When switching from one stock to another, you cannot be certain that the new stock will be a better investment, but you can be certain that trade will incur expenses. Most investors have to pay commissions on their trades, and any capital gains you have on the trade will have to be taxed unless you are in a tax deferred account.
Any action or investment that incurs an expense needs to be examined very carefully because profits are not guaranteed.
Net Alpha < Net Expense Incurred Chasing Alpha
When an individual outperforms their benchmark without taking on additional risk they have generated alpha. The desire to earn greater returns with no additional risk drives many investors to pick individual securities.
In the financial markets, an investor seeking greater returns usually must take on greater systemic risk. Choosing between two investments with the same return, any rational investor would prefer the investment with less risk. When looking at individual securities, this opportunity rarely presents itself to a material effect because traders around the globe bid up the price of any security that offers a higher risk adjusted return, each one of them hoping to eek out a couple of basis points alpha for themselves. This makes attempting to improve risk-adjusted returns through security selection very difficult. The number of eyeballs around the world watching the capital markets makes genuine alpha hard to acquire.
Why is alpha so hard to come by? Because net alpha equals zero. Any alpha acquired by one trader was taken from another on the losing side of the trade. When looking at the market as a whole, alpha is a zero sum game. Alpha constitutes outperforming the aggregate and it is impossible for the aggregate to outperform itself. Thus, we are left with a zero sum game. When you factor in all of the commissions paid by investors engaging in this game, the whole situation is pretty laughable. Chasing alpha is entertainment for many, but so is gambling.
The concept is simple for anyone who has taken a statistics course. Can all of the samples of a population add up to a sum that is greater the population itself? Of course not.
The paper entitled The Tao of Alpha gives an excellent explanation of the problem. It is a must read for anyone who picks stocks or has been funneled into an actively managed mutual fund.
Extra transaction costs are almost a certainty with any strategy attempting to generate alpha. Alpha is a mighty seductress, but chasing it is not worth the risk, especially with money that I cannot afford to lose. By focusing on reducing taxes, commissions, and expense ratios, I feel that I can earn a higher risk adjusted return than an investor who chooses to chase outperformance through costly avenues.