Better than Alpha summary

We often make the mistake of viewing alpha in simplistic terms, when it’s actually much more nuanced. Alpha isn't absolute; it exists along a spectrum.

First, there’s true alpha. This is the generation of excess returns only through selecting securities that differ from the market. This kind of alpha is truly beating the market without tilts like sector bets or dividends.

Imagine the following experiment, conducted by a primitive human. A man drops a few rocks into a river, followed by some logs. He notices a pattern: the rocks always sink, while the logs always float. He concludes that rocks are inherently heavier than logs.

But he’s wrong. This kind of reasoning is an example of the cognitive bias known as the inherence heuristic. We have a tendency to identify a pattern – and then turn it into an explanatory narrative. It’s a superficial way of thinking, but we do it all the time because it’s easier than thinking analytically.

So, our gut instincts are often wrong. Presumably, then, we should avoid making quick decisions and really think things through – right? Actually, it depends. Different kinds of thinking are useful in different situations. 

Let’s look at the model outlined by the psychologist Daniel Kahneman in Thinking, Fast and Slow. Quick, intuitive thinking is called System 1; conversely, System 2 consists of slower, analytical thinking. System 2 thinking generally leads to more accurate outcomes, but it’s also exhausting. Our mental energy is finite.

We've discussed how to approach the initial stages of the investment process with in-depth, System 2 thinking. Most of the time, though, we have to depend on quick, unreliable System 1 thinking. How can we optimize good decision-making in these instances?

Let's look at the due diligence stage of the investment process; this involves a thorough investigation of a potential investment, including risk assessment and the evaluation of past performance. Compared to policy setting, due diligence is less strategic. You don’t need System 2 thinking here, but a framework can help you meet your objectives.

When the wrong person ends up in charge, the results can be disastrous. One organization, the Dallas Fire and Police Pension, found itself in a very precarious financial position as a result of poorly judged real-estate investments. The chief administrator behind these investments lacked relevant experience. His professional background involved running a fast-food restaurant – and his idea of due diligence was taking luxurious vacations in places with potential investment opportunities.

Poor governance doesn’t always lead to financial disaster, but it’s bound to have a negative impact on investment performance. Many research studies on investment governance structures come to the same conclusion: choosing the wrong manager is one of the main predictors of poor investment outcomes.

The myth of the investor with a Midas touch is just that – a myth. Despite all the hype, alpha mostly remains out of reach. Does that mean it’s time to give up on alpha once and for all?

Essentially, the answer is yes. As we’ve seen, alpha is elusive and enigmatic. Once you start looking at the data for public markets, it’s clear that most excess returns were never alpha to begin with. In hindsight, it was probably a result of factors – or pure luck. So if you’re working in public markets, you’re better off forgetting alpha. Instead, direct your efforts toward getting indexes and factor exposures at the lowest possible prices.