The Invisible Alpha

The Invisible Alpha

The connection between Wall Street and Main Street is a quirky one.  For the most part, Wall Street serves Main Street well.  Investment banks, commercial banks and insurance companies match borrowers with lenders and keep the economy running.  However, this synergy is far from perfect.  In many ways, the investment profession has become dominated by the economics of the investment business.  Embedded in today’s Wall Street business models are conflicts of interest that Main Street must aware of and protect against.

One of the more harmful disconnects between Wall Street and regular investors stems from how each group defines success.  Successful investing on Wall Street is very short-sighted.  It is about advancing careers and growing businesses.  Successful investing on Main Street has a much longer-term focus.  It is about planning lives.  While both noble goals in their own right, Wall Street’s pursuit of success ultimately advances its own self-interests at the expense of Main Street investors.

Wall Street Success

On Wall Street, one way to measure the success of investment managers is by comparing their performance to that of a market index or benchmark.  In the finance world, this metric is known as alpha.  Technically speaking, alpha is the active return of an investment on a risk-adjusted basis.  For example, if a U.S. large cap mutual fund returned 12% in the same year the S&P 500 index returned 10%, it is said that the fund generated 2% alpha (assuming no additional risk was taken by the fund to earn returns).

Alpha is a performance gauge on which careers and businesses are judged.  It means bigger bonuses and more assets.  On the surface, a business model that incentivizes outperforming the market seems like a good idea.  Does it work though?

Alpha can only be achieved by outperforming the collective pricing power of millions of investors, and that is no easy task.  In recent years, as the industry has grown in size and sophistication, the competition has gotten tougher.  The percentage of active managers able to generate statistically significant alpha has fallen from about 20% 20 years ago to just 2% today [1].  Additional evidence confirming the elusiveness of alpha can be found in the Standard & Poors annual SPIVA Scorecards.  Most recently (2015), S&P found that 82% of U.S. large-cap fund managers underperformed their benchmark over a 10 year period.  Simply stated, alpha’s tough.

Despite what evidence has proven to be a relatively futile activity, the hunt for alpha is ingrained in Wall Street’s culture.  Unsurprisingly, given the difficulty of the task and the valuable resources dedicated to it, the cost is quite high.  Famed finance professor Kenneth French estimates that over $100 billion is expended each year by investors searching for superior returns[2].  These investors, he concluded, are engaged in a massive transfer of wealth from their own wallets and into the hands of the purveyors of actively managed products and their market makers [3].

In summary, despite large economic incentives to chase alpha, Wall Street fails at the task and in the process, costs Main Street an enormous amount of money.  Fund companies get paid.  Fund managers get paid.  Investors pay.  Alpha on Wall Street has far more to do with a compensation structure than it does with sound investing.

Main Street Success

The word “finance” actually comes from the Latin “finis,” meaning objective or goal.  Finance then, it can be said, is the management of money to meet personal objectives[4].  For Main Street, Wall Street’s statistical alpha is entirely irrelevant.  Main Street investors don’t benchmark their lives to market indices.  Their benchmarks are personal.  Paying for college, saving for a home and planning for retirement have little to do with risk-adjusted returns over the S&P 500 stock index.

What if we take Wall Street’s concept of successful performance (alpha) and transpose it onto Main Street?  This new performance metric cannot be distilled to a single number or used to compare the portfolios of two neighbors.  Achieving it requires patience, conviction, and a willing ignorance of day to day Wall Street operations.  Although there are many, the stories of success tied to Main Street’s alpha go mostly unseen.  They aren’t written about in the Wall Street Journal or featured on CNBC.  Main Street’s alpha is relatively invisible, but unlike on Wall Street, this alpha is very attainable.

Invisible alpha is a direct reflection of how well investors master what is in their control to make progress towards achieving what they truly want out of life.  Charlie Ellis calls this “winning the loser’s game” and Vanguard’s famed founder, Jack Bogle, refers to it as “intelligent investing”.  No matter the verbiage, this is the only alpha that matters to Main Street.  This is what investors should focus on and where the ability of an advisor to influence behavior becomes incredibly valuable.

The Invisible Alpha

Over the years I’ve written hundreds of posts on diverse financial topics but have essentially made the same four points over and over again.  And I’m ok with that.  The points are worth repeating and I’ll continue to do so.  They are simple lessons dedicated to the pursuit of invisible alpha.

Focus on these four rules and you will be well on your way to reaching the goals that matter most.

1. Understand Yourself

“It’s not hard to make decisions when you know what your values are.” – Roy Disney

A good investment plan starts and ends with you.  Your values.  Your goals.  Always remember the “Why.”  By attaching purpose to your investments, doing the right thing becomes much easier.

2. Control What You Can

“You have power over your mind, not outside events.  Realize this and you will find strength.”  – Marcus Aurelius

You cannot control the direction of financial markets but you can control the things that matter most.  Diversify, keep your costs low, be smart about taxes and have conviction in your beliefs.  Your behavior has a bigger impact on your wealth than anything else.

3. Keep it Simple

“Simplicity is the ultimate sophistication.” – Leonardo da Vinci

Complex markets do not require complex solutions.  Complexity sells; simplicity pays.  Avoid the noise.  Be humble and do not mistake information for knowledge.

4. Embrace Uncertainty

“Plans are useless, but planning is indispensable.” – Dwight D. Eisenhower

Accept the reality of uncertainty with open arms.  Financial planning is a process, not an event.  Nothing is perfect and there will be bumps in the road.  As life changes, plans change.  Adapt, adjust course and carry on.

Further Reading…

Real Financial Planning

[1] The Incredible Shrinking Alpha – Larry Swedroe/Andrew Berkin

[2]  The Cost of Active Investing – Kenneth R. French

[3]  Passive Investing Won’t Break Market – Larry Swedroe

[4] Personal Benchmark – Widger, Crosby

Tim Brennan

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