Are You A Real Investor If You Do Not Produce Alpha?

Positive Alpha On 5/24/13

A rare positive alpha day.

Although I’ve admitted to disliking the stock market, there are those rare days when everything goes right and I just love it. Those days are when your shorts go down in an up market, when your longs go up in a down market, your longs go up more during an up market, and your shorts go down more in a sell-off.

Plenty of people proudly proclaim their investment prowess now that the stock markets are back. You’ve got recent college grads who can’t even get an interview at a investment house recommending stock ideas on Motley Fool and Seeking Alpha as freelance writers. Are they confusing journalism with investing?

You’ve got grocery store clerks highlighting their latest stock ideas to customers during check out. Why work at Safeway for $9.25 an hour when you could make more trading stocks full-time?

You’ve got folks who put all their net worth in the stock market and think they’re brilliant because they’ve never seen a bear market having only started four years ago. The best attitude is when asked what if the markets go down? They say they’ll just buy more, as if they have infinite capital and courage.

Even people like me are writing more on the topic of investing while working on a new investment forum. Bubbly bubble perhaps? Probably. At least we’ll focus on short ideas as much as long ideas. A large reason why I’m writing this post is to remind myself not to be delusional in my investing abilities.

It’s very rare to meet someone who has admitted to losing money in the stock market. Perhaps it’s natural to talk about our winners and keep our losers hidden. If you’ve never met anybody who has lost money in the stock market, well let me be your first. I lost about $30,000 in a company called Gastar Exploration (GST) in a span of six months when I kept doubling down thinking gas prices would rebound. Now that was an expensive lesson in commodities trading!

What I do wonder now is whether people are once again being led to slaughter by becoming overconfident in the stock markets. If you start extrapolating 15% a year returns in your portfolio due to the past four years, many of your other assumptions change e.g. age of retirement, rate of savings, spending decisions, and so forth. You might think, “Why work hard and save as much if my investments are going to make me so much money? My $100,000 investment portfolio will turn into $1 million in 10 years!” I recommend everyone run scenario analysis on their portfolios. Be conservative in your assumptions please.

Are people confusing investing with simply the process of saving? When you are mindlessly buying a index fund, mutual fund, or a set list of dividend stocks on a list with every paycheck are you really an investor, especially if you consistently underperform? Let’s discuss.

THE DEFINITION OF ALPHA

Alpha is a measure of performance on a risk-adjusted basis. Alpha takes the volatility (price risk) of a fund and compares its risk-adjusted performance to a benchmark index. The excess return of the fund relative to the return of the benchmark index is a fund’s alpha.

In other words, if a capital asset pricing model analysis estimates that a portfolio should earn 20% based on the risk of the portfolio but the portfolio actually earns 30%, the portfolio’s alpha would be 10%. A 1000 basis point outperformance kicks ass, and if you were an active fund manager you would likely receive a substantial year end bonus. The issue is that you must combine outperformance (alpha) with managing a large sum of money to get paid. Otherwise, who cares. It’s the same with individual investors. If you’re up 40% on a $25,000 portfolio, $10,000 isn’t going to make a difference in your life at all.

If you buy a S&P 500 index fund, your alpha is 0%. Theoretically, your alpha is negative by the cost of owning the fund. Isn’t it interesting to think that with all the praise over index fund investing, you are automatically underperforming your respective index? Think about that for a minute. Trillions of dollars are chasing guaranteed underperformance! At least by investing in an actively managed mutual fund you have a chance of outperformance.

Looking at it from the fund administrator’s perspective, a company like Vanguard doesn’t need to pay a team of portfolio managers and analysts millions of dollars to invest because all Vanguard is doing is rebalancing the portfolio whenever there is an inflow or outflow of funds and a change of names in various indices like the S&P 500, which doesn’t happen too often. They are administrators, which should eventually be replaced with machines.

There’s also a very interesting dichotomy in the money management industry. Hedge fund managers will look down on active mutual fund managers for being “index huggers.” Index huggers are money managers who basically buy all the stocks in their benchmark and only overweight a few names so as not to underperform too bad in case their calls go wrong. They have no guts in other words. Meanwhile, active mutual fund managers look down on index managers given they don’t have to use their brains.

I’m never going to stop trying to outperform the markets with a portion of my equity holdings. The problem is that in order to generate alpha, I’ve got to stay on top of my portfolio like a hawk because of both endogenous and exogenous variables. Sometimes the effort will result in a positive 7% alpha in the month of May due to Chinese internet stocks. Other times I’ll work harder and generate negative alpha. Whatever the outcome, I plan to keep trying. I recognize that most active fund managers underperform their benchmarks hence why I only dedicate a minority of my equity to active investing.

SAVE, ALLOCATE, HOLD = INVESTING?

If you religiously set aside 20% of your paycheck into a low cost index every year for the next 40 years of work (holy crap that sounds long), you’ll likely do very well if history is any guide. However, everything is relative when it comes to finance. If everyone else who earns the same as you sets aside 20% of their paycheck in the same index fund, you are running in place. If everyone else who earns the same as you sets aside 30% of their paycheck in an actively managed fund that outperforms your index fund by just 1% over 40 years, now you are really falling behind!

Anybody can save money and automatically contribute to a fund that is run by someone else. Can anybody analyze a cash flow statement, forecast operating margins, build a dividend discount model, and put their own money to work in a hopefully risk tolerant way? Probably, but it requires education and effort.

One of the great jobs in finance is managing a Fund of Funds. You essentially raise capital to invest in various funds who you think will generate alpha. Your job is to research historical performance, stability of the fund management team, and analyze the portfolio manager’s investment acumen through interviews and presentations. A Fund of Funds manager should have his or her own investment insights by which to compare notes when choosing new funds. But other than that, is the Fund of Funds manager really an investor? Hard to say. I would argue that a Fund of Funds manager is an investor in people, not stocks.

SAVINGS IS A GOOD WORD BUT DON’T CONFUSE ITS MEANING

Before you can invest, you must save. We’ve gone through various savings strategies and savings benchmarks in the past. We’ve also discussed how one can find higher paying jobs in order to boost the absolute amount of their savings. Saving is the easy part. Any knucklehead can save. What to do with your savings to improve its money strength is truly the hard, but fun part of personal finance.

The reason why investing is hard is because investing is a zero sum game. You can and will lose money in investing, no matter how much you think people only make money in the stock market. With savings, you either save more money, save the same amount of money, or save nothing. You don’t start impaling your net worth by not saving. (See Proper Asset Allocation Of Stocks And Bonds By Age)

Sites that focus on minimalism and frugality are very popular because the topics are easy to understand and implement. However, it’s clearly much better to make more money than cut costs to improve one’s net worth and lifestyle because there is only so much in costs you can cut. I say pursue a good amount of frugality in your life as a comfortable base case scenario and then go for glory.

The wealthy own most of the assets in the world which is why most people don’t feel the same amount of satisfaction in a bull market. It’s up to you to find your own outperformance. Let’s not confuse investing with the basics of saving. Perhaps the definition of “real investor” can simply be answered with a question: Would you trust the person to invest your retirement savings? I hope this post gives you something to think about now that everybody is a money making machine.

Related post: Real Entrepreneurs Are Successful – The post talks about what defines an entrepreneur vs a hobbyist to prevent folks like me from wasting too much time going at things alone.

RECOMMENDATION TO HELP YOU MANAGE ALPHA

Free Wealth Management Tool: Sign up with Personal Capital to track the performance of your investment portfolios. They’ve got a fantastic Investment section that measures your risk and let’s you calculate various return and contribution scenarios. Furthermore, they’ve got a fantastic 401(k) Fee Analyzer tool which spits out how much in fees you might have no idea you are paying. After finding out I was paying $1,700 a year I switched out of a Fidelity Growth Fund and into a similar fund from Vanguard that costs $1,200 less. Fees eat away at alpha and takes years off your retirement goal targets if left unchecked!

INVESTMENT PLATFORM RECOMMENDATION

Invest In Ideas Not Stocks: Motif Investing is a terrific company based right here in the San Francisco Bay Area. They’ve raised over $60 million dollars from smart investors such as JP Morgan and Goldman Sachs because they are innovating the investment landscape with their “motifs.” A motif is a basket of 30 stocks you can invest in, which are aimed to profit from a specific idea or underlying theme. Let’s say you think new housing construction is going to quicken in the US next year. You could buy a housing motif which might contains Lennar, KBH, Home Depot, Bed, Bath, and Beyond, Zillow, and more in various weightings.

You can buy a basket of 30 stocks for only $9.95, instead of buying them individually for $7.95 through a typical broker. You can build your own motif, buy one of the motifs created by Motif Investing, or buy a motif by a fellow Motif Investor with a great track record. You can even buy retirement motifs, much like target date funds, except you don’t have to pay the 1% management fee. You get up to $150 free when you start trading with Motif Investing. Given my focus on buying winning long-term ideas and ignoring the short-term volatility, I really like Motif Investing’s value proposition for retail investors.

Updated on 12/1/2014. Let the bull market continue. Just don’t forget to rebalance and manage your risk exposure.

Sam started Financial Samurai in 2009 during the depths of the financial crisis as a way to make sense of chaos. After 13 years working on Wall Street, Sam decided to retire in 2012 to utilize everything he learned in business school to focus on online entrepreneurship.

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Comments

  1. says

    I hear people talk all the time about how great they are at investing. Heck I use to be one of them. But now I follow more and try to make smarter decisions. I have seen people invest in stocks have a huge run up. Wont sell off any positions only to lose the gains and the investment. True savings and investments are two different beasts and should be treated as such. Im not sure to answer your question if you don’t produce alpha you should be considered a real investor. But then it begs to question what is a “real investor”.

    • ristlin says

      To me, investing is about buying low and selling high. That’s it. I don’t believe in margin calls, options, or shorting — they are all too complicated for an amateur investor. I look at a stock, read financial reports from the company, Market Edge, Standard & Poor, and Reuters. Then I look at how the company has impacted my life. If I find it has made a positive impact (a product/service I use, or that is involved in the supply chain) then I decide I want to own it. But only if the “price is right.” Here’s an example:

      I’ve always liked Netflix (as a service) and wanted to own their stock (this was around the time they were sporting a steady $300 stock). The subscriber numbers were still healthy but the growth was tapering off a bit. So I held off from buying. Then, they had their PR debacle, which brought them down initially to around $150. I thought this was a good price and decided to move in. A few weeks later, they made another PR mistake and their price dropped to mid-$60 seemingly overnight. As a user, I felt slighted by their PR mistakes, but it didn’t negatively affect my ability to enjoy their service (the higher price was annoying, but still laughable compared with purchasing cable). I broke a “investing rule” and decided to double down. I did this for two reasons: (1) I knew the stock was no longer a Wall St. darling, meaning it would be awhile (if ever) for it to recover to $300 and (2) the subscriber losses did not warrant an additional 50% drop in value for the stock. So I brought my average stock purchase cost to around $100/stock. A few months later the stock recovered, and I sold out at $115 or so — making a pretty nice profit.

      After a few months of movement, they announced an upcoming original series. I took interest in their strategy and felt there was still quite a bit of value in Netflix despite the flood of competitors in the market (Hulu, Amazon, etc.). However, the biggest drive was my own experience with the competitors: they were good, but the overall experience was not as good as Netflix. Hulu had ads and Amazon was clunky. I bought at $107, endured two drops (positive reports, but the market was not paying attention), then finally cashed out in the recent rise.

      I could have made much more than I did had I stayed around a bit longer (its at $220 right now), but no one is perfect. The important thing is that I stuck to my plan and profited from it, twice.

    • says

      One way to answer the question is to see whether you’d trust the person to manage your money. If yes, then check the real investor box. If no, then probably not. Hence, a track record of outperformance is probably what’s most important.

  2. Ricky says

    I think alpha is only considered when determining investment success. An investor is simply someone who purchases something he considers an investment in order to generate a return. Generating a return I think is the key element to keep in mind. So, of course, no, having positive alpha doesn’t make you an investor, solely.

    As far as dividend stocks go – please – sell your dividend stocks off so that I can get a higher yield! More power to those that want to jump ship to the security of the U.S. Gov when there are plenty of great, healthy companies that consistently raise their dividend and have never missed a payment. Rising interest rates can only help those sitting on the sidelines right now. Then again, we know that the 10 yr yield probably wont’ reach anywhere near 3-4% anytime soon.

    • says

      Man, dividend stocks have gotten CRUNCHED recently with the surge in treasury yields. REITs especially. It’ll be interesting to see how big the correction is.

      I’m always curious why younger folks invest in dividend stocks when the reason why companies pay dividends is b/c they can’t find better opportunities within.

  3. says

    I think most people have never even heard of alpha or don’t fully understand what it means. Same goes for hedge funds. I have to chuckle when I hear college grads sayihg they want to start their own hedge funds. Good for them if they can do it some day but it so much harder than they can even imagine. Generating true alpha is no easy task.

  4. says

    There’s a reason why billions of dollars flow into those slightly negative alpha index funds. Because for most investors that’s FAR better than they’ll be able to do on their own, or in an actively managed fund. Especially as you lengthen the investing horizon. I don’t think anyone here needs the stats about the performance of active funds vs the index repeated.

    It comes down to generating returns on your money, and the stock market is still the best way to do that. I know I’m not smart enough to beat the index on my own. So even if I take the index returns minus fees I’m still generating a higher return on my money than I would anywhere else. So I’ll take that, and let everyone else swim against the tide in the quest to generate alpha and be a “real investor”.

    • says

      I agree. Over the long run it’s brutally hard to outperform. However, you just need some big wins in the short-run to get really wealthy relatively speaking. Look at all the hedge funds who made enormous returns in a 2-5 year time frame and have shut down.

      • says

        I do take a small portion of my overall investments and try to hit a few home runs, so its not like I’m against trying. I just think a person would be naive to believe that they had a chance to constantly crush the market with their overall returns.

  5. says

    On any particular day, some of my stocks/funds go up and down. I am happy if my overall portfolio increases. I set up my asset allocation in such a way to avoid most of the volatility and all of my stocks/funds trending down at once. I want to preserve capital, but still grow my portfolio. I don’t know enough to maximize my growth and probably would make bigger mistakes. I think time in the market offsets many mistakes.

  6. says

    I’ll always think total returns are more important than generating alpha because I don’t think markets are all that efficient by the simple measure of CAPM. Low beta stocks have crushed high beta names on a risk-adjusted basis in markets all around the world. They’ve also outperformed for years and years on a total return basis. In an efficient market, that wouldn’t be true. They should have the same risk-adjusted return, and high beta names should crush low vol stocks as measured by total returns. I don’t think it’s all that surprising that the world’s best investors are those who completely ignored the idea of alpha and beta.

    Repurchase authorizations are my favorite indicator of froth. FactSet publishes free quarterly buyback reports that are a goldmine for a top-down perspective. Buyback authorizations are an excellent indicator of market froth, since repurchases as a value creation tool peak with investor optimism.

    • says

      The idea of alpha is to simply outperform your benchmark by as much as possible. If you consistently can’t, why is an investor paying you to manage money? They shouldn’t.

      And from a retail investors point of view, the point is not to be so delusional as to think you’re such a great investor that you do unwise things with your future like quit your job to just invest in stocks or not save b/c you think your returns will go on forever.

  7. says

    Anyone who is deploying money to generate a return is an investor. They may be a great investor or a poor investor, or an aggressive or a conservative investor depending on their temperament, skill, and goals. But they are all investors.

    I haven’t tried to calculate alpha for my portfolio yet, but it’s certainly something that I would like to do in the future.

      • says

        I did a very rough envelope alpha calculation. My portfolio has an annualized return of about 20% over the last 37 months and a 0.85 beta. Using a risk free rate of 2% and a 15% expected S&P return (the annualized return over the same timeframe), I’ve got an alpha of 7%.

        I don’t put a lot of faith in this number as it is very rough (I didn’t have time to build a massive Excel sheet), but given that most of my stock’s betas are below 1 it makes sense.

  8. JayCeezy says

    Q: what is the difference between a journalist and an investor?
    A: One is an ethically-challenged parasite, creating nothing while furthering a personal agenda, and claiming expertise based on degrees and certificates while rejecting any accountability for error, and claiming opinion as fact. The other one attempts efficient use of capital to make money.

    Seriously, ladies and gentlemen, interesting topic. Oddly, I just got out of the whirlpool where I listened to a 59 year-old dental assistant tell her friends from the aquarobics class that “there will be one more crash, then Obama will be out, and the markets will go up, up, up!” A contrarian sign, no doubt, and I scrubbed extra hard in the shower to get the ignorant confidence off me.

    I have been tracking my risk-adjusted portfolio against alpha since 1997. In aggregate, I have underperformed for 17 years, at 94.5%. Basically my beta (risk) was 1.0 (S&P 500, 75% of the overall U.S. equity market) until 2009. Today, it is .08 (8% in equities, 92% in cash instruments). Not many people have bothered to keep a track record, and instead let the memories of their victories become burnished with the bright luster that only the sands, wind, and waves of ego and time can bring.

    F*ck it! Let them have their memories!:-) But I will straight up say it; I have spent thousands of hours at this, and cannot beat the market. But I wish everyone well in their attempts to do so.

    One other interesting tidbit from my investing experience: if I had invested strictly in CDs with a Beta of 0 for the past 15 years, $1 would be worth $2.02 today. If I had invested strictly in US equities (reinvesting dividends) with a Beta of 1 for the past 15 years, $1 would be worth $1.28 today. If you do not understand the point of that information, after the next bear market you will.

    Lastly check out these Secular cycles. And enjoy the Cyclical while it lasts!
    Bear: September 1929 to June 1949….19.75 years
    Bull: June 1949 to February 1966……..16.67 years
    Bear: February 1966 to August 1982…16.5 years
    Bull: August 1982 to March 2000……..17.6 years
    Bear: March 2000 …………….and still in progress

    • says

      Interesting note on the CDs!

      The good thing is that your wealth increased in value over the years at least as others have pointed out with their goal of investing.

      I have no delusions that I will consistently beat the market, hence I only have a minority position where I punt around searching for unicorns. I’ve found one 13 years ago, and have been searching for one since.

  9. says

    I do agree with you that bull markets produce many more “investing experts” because in a bull market everybody wins. It’s the bear markets that separate those who were riding the way and crash from those who follow a strict system and are not afraid of the occasional downturn.

    In regards to how should be considered an investor, I lean more toward a broader definition. An individual who is investing 100% in index funds and getting his average market return is as much of an investor as somebody who spends 40 hours a week watching his portfolio to get a few extra %. I’m ok with both and personally prefer the middle ground – I have a core index fund portfolio and about 30% in tactical holdings, such as individual stocks.

  10. says

    There is alpha to be attained in the markets, but unfortunately not much of it it earned by individual investors, especially in active mutual funds. Most goes to institutional investors in funds not available to the public. Here are some stats to back this up:

    – only about 20%-40% of active funds outperform in a single year
    – over 5 years only 3% manage to stay in the top 20%
    – Morningstar did a study and found that the best predictor of a fund’s success is the expense ratio (ie, index funds have a built in advantage with low fees and transaction costs)

    Read more here: http://www.ritholtz.com/blog/2013/05/brain-on-stocks-newport-beach-may-1011-2013/

  11. says

    My feeling is a person who’s focus is solely on return is really a gambler. A person who focuses solely on capital preservation is really a saver. An investor is a person who figures out how to achieve their desired return with their own acceptable level of risk. For any targeted level of return, why accept more risk than you need to? You need to know what your goals are and then craft a plan to achieve those goals. If your goal is just to get “more,” you’ll never get there.

  12. says

    I suppose I’m ok with not being called a real investor. I think my time is better spent working on my career than trying to become an investor. I don’t think I could justify trying to pick stocks on my own (instead of indexing) because there’s a huge probability that I’ll do even worse. Maybe it will make sense when my portfolio is bigger, but for now, call me a fake investor because I’m just sticking with the index.

    • says

      It’s just semantics. The goal of this post is to get investors thinking more about what they are doing and not just blindly dump money into the market with each paycheck.

  13. Asx dividend says

    Investing is very important for all of us. It helps you to meet your longer term needs and larger financial goals. By investing wisely you can improve your standard of living and create wealth for the future.

  14. says

    I was in the “smarter then thou” crowd straight out of college. Made a bunch (relatively) on stocks really quick and thought I was a king. Then I got really cocky and started investing in these crap start up penny stocks on margin and got burned, burned big. Still trying to recover from that. Definitely taking a less risky approach from here on out, but still trying to do better then the s&p.

  15. says

    “If everyone else who earns the same as you sets aside 20% of their paycheck in the same index fund, you are running in place.”

    Two issues with this statement.

    1) My financial success isn’t dictated by the returns of everyone else. It’s dictated by my own personal goals. Everything else’s returns are irrelevant.

    2) Not everyone else is doing that. It’s similar to saying “if everyone else became self-employed, our economy would crumble, so don’t become self-employed”.

    Investing is about reaching goals, not producing Alpha. As long as you can do that, you’ve succeeded.

      • says

        No, honestly I couldn’t care less what other people are doing. Everyone else could be Warren Buffet and as long as I’m able to live my life the way I want, why should I care?

        • says

          Because if everybody was Warren Buffet, it would probably cost millions to buy your own house or tens of thousands to rent, and everything else would be more expensive too, making it difficult to achieve your desired lifestyle.

          The point of this post is to highlight the relativeness of finance.

        • says

          Oh I understood that that was probably where you were going with it, it’s just not a realistic example. In the real world, I don’t have to produce alpha to achieve my goals. That’s just not a reality. So focusing on a theoretical world where I do have to produce alpha isn’t a worthwhile activity. And in reality, most people don’t produce alpha, and most that try end up losing. So the answer for the real world that we actually live in is no, you do not have to produce alpha to be an investor. And I would even argue that for the vast majority, you’re actually a smarter investor if you don’t even try.

          If you want to talk about relativity, you only need to talk about inflation. And really only inflation as it relates to the things you specifically purchase. I need my money to keep being able to but the things I want to buy. Beyond that, everything else is irrelevant.

          • says

            Sounds good Matt. One of the most positive things I’ve come away with is that most readers have plenty of money to live a happy life. The economy really is improving and it’s great to hear so many positive anecdotes.

  16. JayCeezy says

    Sorry to bump this late. Just re-read ‘Black Swan’ by Nassim Taleb, and highly recommend it to anyone attempting to grasp what is happening in this unpredictable world. This really is a time unlike any other, financial monsters lurk beneath the waves that appear calm for the moment, and the problems/behavior of governments and consumers that created the panic/recession of 2007-09 have not been corrected. The author grew up in a country that was devastated by socio-political conflict, and his family left. What was a Western society, with wealth/laws/education/freedom was changed dramatically, and permanently. Those of us fortunate to grow up in the U.S. take it for granted that there will always be good jobs, wealth opportunity, and legal protection. Maybe not, as Taleb writes.

    Anyway, Taleb keeps 90% of his personal portfolio in risk-free U.S. T-bonds (not funds), held to maturity. The other 10% is a “punt” allocation, where he takes chances in his quest for alpha. By default, I have implemented a similar investing philosophy and allocation. Just thought it would be of interest to anyone reading this post.

    • says

      Didn’t realize Taleb had 90% in US T-bonds. He is more extreme than me, but the concept is the same. Protect the nut like Sparta, and use a portion of your net worth in a quest for great Alpha. Take some risks while you are young. It’s too late as we get older.

  17. B.D. says

    Hello FS?
    I’m very interested in your response to your quote:

    “The best attitude is when asked what if the markets go down?”

    What is your opinion FS?

    Inverse ETFs? Wait-Buy-Low? Shorts? Longs? etc….

    I (we) would be supremely grateful for a detailed response…(new post perhaps?)

    Fantastic blog! You are my new favorite!

    B.D.

  18. JW says

    At least you admit that you only “devote a minority” of your portfolio to active investing, i.e., seeking alpha.

    It’s a great topic to write about and I’m glad you’re honest with the fact that seeking index performance is not only more time and cost efficient for every individual investor but it’s also less risky and risk aversion (and it’s fight against greed) is an important thing to manage.

    Devote majority of your money to tracking the market performance to the risk level you’re comfortable with (or is appropriate for your age, etc) and only dabble with the long and short bets (err active trading) with money you’re comfortable losing if you end up on the wrong side of the transaction.

    • says

      Ive made about $210,000 trading this year so far, largely due to the Chinese Internet stocks I wrote about and Apple. It’s not bad, but compared to my overall portfolio where I didn’t do any trading, it’s still much less. I enjoy trading and it helps keep the mind sharp and up to date.

      How have you done?

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