Dumb Alpha: Do the Right Thing
I admit I have crossed the midpoint of my life expectancy by now.
One of the side effects of becoming “an old fogy” is that you start to feel flattered if young women smile at you. Another is your sudden fondness for expensive sports cars. And a third is that you start to give advice to younger people on what your experience has taught you about life.
So raise your hand if you are currently doing any of the following:
- As a private investor: Checking your portfolio performance on a monthly, weekly, or even daily basis.
- As a pension fund trustee: Starting your board meetings with a review of the fund’s quarterly performance.
- As a portfolio manager: Wondering if the weight of the health care sector in your benchmark is 15% or 16% to adjust the sector exposure of your portfolio accordingly.
- As an adviser: Recommending an innovative new financial product that you never before invested in yourself.
- As a financial professional of any sort: Watching financial news programs to “follow the markets.”
In my career, I have been guilty of most if not all of the above and I have come to regret it. So let me put my imaginary pipe into my mouth, adjust my glasses, and explain to you why one of the best ways to create “dumb alpha” is not to do any of these things.
Investing isn’t hectic, it is calm and measured.
Today you can check the value of your investments on a minute-by-minute basis if you want. But just because you can doesn’t mean you should. Investors who trade more have lower returns, as Brad M. Barber and Terrance Odean demonstrated more than a decade ago. And checking your portfolio more frequently will inevitably lead you to trade more.
It is hard for investment professionals to just sit there and do nothing. Resisting that urge to adjust your portfolio becomes particularly difficult when you’re faced with losses. Loss aversion means you suffer losses more than you enjoy gains. And what’s still the best way to avoid losses? Don’t look at your portfolio.
Assume an equity portfolio with a 10% annual return and volatility of 15%. The probability of a positive return over any given year is 93%. As a result, an investor who evaluates the portfolio once a year will experience a loss once every 10 years or so. If the same portfolio is evaluated quarterly, a loss will occur about once every four quarters, or once a year. And if that portfolio is evaluated daily, roughly 120 days a year will register losses.
It takes superhuman discipline not to change a portfolio when you are confronted with losses 120 times a year. But the best returns in the long run are achieved by adhering to a well-diversified investment strategy that lets you reap the benefits of the different risk premia available to long-term investors.
To stay calm and measured, you need to turn off your Bloomberg screen, close your Excel spreadsheets, look at your performance only sporadically, and avoid the temptation to tinker too often with your portfolio.
Investing isn’t precise, it is rough and dirty.
Investing isn’t watchmaking either. As an investor or portfolio manager, you cannot precisely manipulate the mechanics of the market the way a watchmaker can the mechanics of a wristwatch. If a stock or a bond has a portfolio weight of less than 2% or an active weight of less than 2% compared to the benchmark, it is almost guaranteed that the effect on the overall portfolio will not be meaningful in any practical sense.
And now think about the time spent analyzing the details of stocks that will end up with an allocation of 2% or less in the portfolio. Each of these details has a miniscule influence on the overall stock performance, and the overall stock performance has a miniscule influence on the overall portfolio.
Just because you can calculate risk exposures to the second decimal place and adjust portfolio positions to the basis point doesn’t mean you should. Fighting for every basis point is best left to money market fund or government bond fund managers who have to because of current central bank policies.
If you work in the equity space, across asset classes, or in any asset that has some volatility, always remember that even the best model can only explain less than 50% of the variation in returns when applied out of sample — and out-of-sample tests are the only ones that count.
What does this mean? Over 50% of your returns will be noise. And that noise will inevitably drown out any benefits accrued from fine-tuning a model or investment portfolio.
Investing isn’t rational, it is emotional.
The financial industry is incredibly innovative — mostly when it comes to reinventing the wheel. For most investors, the simple and transparent solution will do just fine most of the time. But every once in a while an innovation comes along that benefits investors as a class. Just think: Where would we be without the limited liability company, the stock exchange, diversification, the mutual fund, the index fund, options, or futures?
Thanks to all of these inventions, investing has become cheaper, risk management more effective, markets more liquid, and access to investments more open. Ultimately, financial markets are among the most democratic institutions in the world today.
But very often financial innovation is a recipe for disaster. Investing may be rational, but money is emotional, and when risks — or opportunities — materialize, emotions take over and investors make crucial mistakes.
I have made it a rule to recommend only those investments that I have experienced myself. If a new innovation comes along, I tend to add it to my own portfolio with a little bit of money just to know what it’s like to live with it. Experiencing a new innovation firsthand will elicit the same emotions in me as it will in my clients. And only then can I judge if the investment is appropriate for a specific investor. Emotions cannot be imagined. As a portfolio manager or adviser, you have to experience them to improve your recommendations and decisions. Research shows that fund managers who invest much of their personal wealth in their mutual funds generally outperform. Similarly, advisers who eat what they cook tend to cook better.
Investing isn’t entertaining, it is boring.
Is there a television on nearby turned to CNBC, Bloomberg TV, or any other financial news channel? If so, please get up and switch it off. Now. Don’t worry, I will wait here for you . . .
Let me explain why you shouldn’t watch what I call “Bubble TV.”
The people working at Bubble TV and their counterparts at financial newspapers, investment newsletters, etc., are not in the business of providing good advice. They are in the business of selling airtime, newspapers, and newsletters. And the best way to attract attention is to appeal to the emotions and instincts of their viewers and readers.
“If it bleeds, it leads” is an old saying in the news business. Spectacular earnings surprises and cratering stock markets generate more viewers and readers than stories about meeting earnings expectations and stock markets grinding their way up.
“Experts” who want to be mainstays on Bubble TV have to entertain. And it is much easier to accomplish that by stoking people’s fears of a crash or their desire to get in early on the next superstar investment. As a result, Bubble TV is full of “news alerts,” “breaking news,” and pundits predicting imminent doom or eternal bliss — often both at the same time.
But studies have shown that TV experts make bad investment advisers. So keep your TV switched off and focus on what really matters in investing: having a thorough understanding of each investment and how they interact in a diversified portfolio.
Investing is a focus on simplicity.
The purpose of the Dumb Alpha series is to reduce the complex world of investments to straightforward rules that work in real life at the portfolio level as well as the behavioral level.
So take it from an old fogy: In investing, the simplest approaches usually work best. Follow that advice and maybe you’ll be able to afford that midlife-crisis sports car.
If you liked this post, don’t forget to subscribe to the Enterprising Investor.
All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
Image credit: ©Getty Images/CSA-Archive