Assumptions

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.

Conclusion

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.

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2 comments:

  1. The paper, The Tao of Alpha, is very poor, essentially worthless.

    The premise, that alpha is a zero sum game is correct, when qualified as to the market.

    However, in attempting to prove or elaborate on this point, the author(s) made many mistakes in presentation or calculation.

    For example, in many places it claims that 50% of those seeking alpha will lose, or that one will lose for every one that gains excess alpha. In reality 33% may win and 66% may lose and 1% may break even; or 1 may win and all others lose.

    Also, the necessary qualification on market removes all meaning from the argument. Is the market the entire world so if I choose to invest only in the U.S.A. market am I seeking alpha or am I accepting beta? What about the S&P 500 vs. entire U.S. market? What about Nasdaq instead of S&P 500? If my benchmark is the Nasdaq then by buying Nasdaq I am accepting beta, but if my benchmark is the S&P 500 or total U.S. or total world then buying only Nasdaq is seeking alpha. Yet I did not change my action, only my perspective.

    What if you add something else to the mix of stocks in your portfolio, like cash, gold or U.S. Treasuries? Then what is your benchmark?

    Claiming the S&P 500 is your benchmark for that portfolio is delusional because of the other assets you hold. Holding assets other than your benchmark means you are seeking alpha.

    Or are you individually accepting beta for the stocks, accepting beta for the cash, accepting beta for the gold, and accepting beta for the treasuries? Of course you are, at the same time you are seeking alpha over the S&P 500, seeking alpha over the Nasdaq, seeking alpha over the total U.S. and seeking alpha over the total world.

    In other words, the concept behind paper is meaningless, and the only value is that seeking alpha is maybe expensive and is maybe risky. But only if you change your perspective, and you keep doing the same thing. What nonsense. Hope we all got that after wading thru the errors.

    And what about derivatives? (options, etc) Oh, right. They are a different market, or part of the entire world market. So if you don't buy and sell options in the correct proportions, you are seeking alpha!

    AgAuMoney

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  2. You have some valid points, but at they end of the day its just nitpicking. Does it really affect how one should invest?

    When talking about alpha, it would be most correct to say that for every dollar of positive alpha there is a corresponding dollar of negative alpha. That is slightly different than for every winner there is a loser, but we are really splitting hairs at this point.

    You are also very correct to say that the choice of a benchmark is critical to calculating your alpha. I think this was actually a strong point of the paper. Some managers hide behind a false comparison, disguising their excess returns from a chosen index as alpha, when they simply got lucky with beta risk.

    I am puzzled about your claim that derivatives should be part of an index because all returns from derivatives net out to zero. Why would one even bother tracking the returns of them in aggregate? I think it makes since to exclude them from a benchmark for calculating alpha.

    I do appreciate the philosophical questioning of the definition of alpha when constructing a diversified portfolio. I have entertained some of the thoughts you were writing about.

    Perhaps we should compare ourselves to a portfolio of every financial asset with market capitalization weighting? Perhaps that should be the index to which we should compare any investment portfolio?

    No matter how we define alpha in the context of a diversified portfolio across different asset classes, I still think it is prudent to focus more on minimizing expenses. That is really the action point of this post.

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