Investor Facts: What Is Alpha?

Alpha is a finance term which means how much an investment returns in excess of the market as a whole.

There are many ways to think about the market as a whole, but the most common is a stock market index, such as the S&P 500 or the Dow Jones Industrial Average.

While theses two indexes measure very different parts of the stock market, they both measure the stock performance of large U.S. companies.

If the return of, say, the S&P 500 is 10% in a given year, then the challenge of an investment manager is to return more than 10%.

If the manager is able to give an investor a return of 11%, then the alpha that manager can claim equals 1%.

An additional 1% return is significant, especially if it can be repeated. For instance, a 10% return on $10,000 over two decades turns that initial investment amount into $67,275.

An 11% return, if consistent, turns $10,000 into $80,623. That’s 18% more money at the end of 20 years.

There are a few problems with trying to get alpha from an investment manager. One of them is cost.

The typical actively managed mutual fund charges 1.25%.  The typical active bond fund charges 0.90%.

So the investor must get at least that return and more to truly experience the alpha promised by the manager.

The second problem is performance. Very few active managers are able to beat a given index in any one year.

Regularly, as much as 80% of them fail to do so even before calculating costs.

Choosing a manager who can find alpha and deliver it for years and years is tremendously difficult. Doing it on your own is even harder.

Finally, the trading activity involved in trying to time entries and exits from stocks or bonds is a cost that few consider. Yet it’s a real cost.

First of all, there are commissions to pay for buying and selling stocks, bonds, and mutual funds.

Second, there is a lot of price friction, something called the “bid-ask spread” that introduces costs that are difficult to quantify but nevertheless are real.

Buy high, sell low

Finally, there is the emotional risk that comes with actively trading stocks and bonds.

If a stock you own is doing well, you might believe that the success is a sign of your intelligence in making the trade.

Thus you hold the stock, or even buy more, as it rises. Eventually, the price falls back and you continue to hold the stock.

In time, your gain could turn into a loss.

On the downside, then, the decline in the asset’s value seems to be not an indicator of your abilities but a sign of the market’s irrationality.

So you stay in the stock until it falls to a very low point.

At that low point, the emotional toll becomes extreme — and you sell. Because of the emotional cycle, you can manage to buy high and sell low repeatedly, a sure way to lose money.

Alpha is a reasonable goal for any investor. But achieving it is no easy feat, while the risks inherent in the attempt can make passive investing — simply holding an index fund — an attractive alternative.

MarketRiders, Inc. is a registered investment adviser.  Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies.  Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.