Anyone can generate a return from an investment. When you buy bonds, you receive coupons for instance. Generating excess returns is however a different story. What do I mean by excess returns ? Simply put, these are returns over and above a market benchmark (e.g. the SP500 stock index).
This is Alpha.
Many professionals will tell you it’s impossible and you’re better off being a passive investor with market tracking instruments. However tracking instruments like ETF’s are a bit of a misnomer, they should be called market lagging instruments. After taking into account expense ratios, management fees, brokerage etc, you’re not matching the benchmark for returns, you’re lagging behind the benchmark. Basis points matter. You can tilt a portfolio with intelligent allocation strategies and achieve market beating over the long term. The key is acknowledging that asset class performance is dependent upon the economic conditions. There isn’t a single asset class that performs across all economic conditions.
All alpha strategies can be broken down into two approaches:
(1) Buy Risk
The first and most common path to excess returns involves buying risk with the expectation that you’ll be compensated by a reward. Ideally, the risk / reward ratio is asymmetric; you stand to gain more than you could potentially lose. Any form of speculation is simply buying risk. Yes, you may have a quantified edge backed by cutting edge models developed by the brightest PhDs in the business, but you cannot predict the future. After all the analysis, you put your money on the table and buy risk.
Often, the thing that separates the best in the business from the amateur is that the pros buy risk with a high multiple of return per unit of risk. The amateur doesn’t consider the relationship between risk and reward and can inadvertently end up buying a large amount for risk for a very small reward. Luck often reinforces this behavior, but only for so long.
Buying risk is the approach that attracts all the focus. The pros play in this space because they have the resources to compete. Amateurs are enticed by the lure of quick riches. Unfortunately the approach appeals to many of our behavioral biases, which can make it addictive.
What does buying risk look like?
- High risk, high reward (Ideally!)
- Thrives in bull markets.
- Short time horizon
(2) Limit Losses
Markets have drawdown periods, it’s inevitable. The average drawdown for the SP500 stock index from 1928 – 2018 is 24%. Remember, that’s the average. From 1929 – 1932 the index experienced a maximum drawdown of 86%. More recently, in 2008 – 2009 the drawdown was over 50%. If we can anticipate these major events and shift our allocations accordingly, we have a dramatic advantage. We no longer need to buy risk to beat the market and generate alpha. We just need to tilt our asset allocation during drawdown periods.
In order to limit losses, there needs to be some element of market timing. To passive investment proponents, market timing is a dirty word. However there are some basic timing rules you wouldn’t even question. For example, would you carry lots of exposure to stock markets in the midst of a recession?
You don’t have to forecast every bear market, anyone who tells you they can do that is spinning a fairy tale. You do need to have the right tools and asset allocations to respond to bull and bear markets accordingly. It’s not about picking tops and bottoms and capturing 100% of any major move. Accept that the market will move before you adapt. If you capture 50% of the move, you’re doing very well indeed. That’s the beauty of this approach. Near enough is good enough.
What does limit losses look like?
- Lower risk (but not necessarily lower reward)
- Thrives in both bull and bear markets.
- Longer term horizon.
It’s really important to realise that neither of these approaches is ‘superior’. Nor are they mutually exclusive. The best investors combine elements of both. While you can definitely adopt Type 2 exclusively, I would argue that adopting a pure Type 1 approach and buying risk is not wise. At least part of your portfolio should adopt a Type 2 approach. This automatically reduces the risk for your Type 1 investments (assuming minimal correlation), improving the asymmetry of risk and reward.