For many investors one of the lingering uncertainties is whether or not we are better-off pursuing an active investment strategy, or whether simply placing funds into a professionally-managed or low-cost index fund, would yield higher returns.
In this issue of BullsEye Insights we take a closer look at a key measure of stock market investing performance - alpha - and whether investors are wasting their time fighting against the odds by attempting to beat the financial markets when investing or trading for themselves.
So what is Alpha?
Alpha is a measure used by professional investors to quantify their performance relative to a stock market benchmark, such as the Dow Jones or FTSE 100.
And just as a reminder before we go any further, even in a bear market, it is still an achievement to beat the market!
Alpha is commonly represented as a percentage, with either a positive or negative value. As such, an alpha of 0% indicates that the performance of an investment or portfolio of investments has tracked perfectly with its comparative stock market benchmark, and that the investor has not added (or lost) any value when compared to the performance of the broader market.
An investment or portfolio of investments that outperforms the 'market' has a positive alpha value and underperformance relative to the 'market' results in a negative alpha value.
For the purposes of alpha, the 'market' is represented by a suitable market benchmark, chosen by the investor. The market benchmark acts as a proxy for the overall performance of the broader market.
For example, if the market benchmark return is +5% over a given time horizon and your stock portfolio returns +8% over the same period, your alpha result would be +3% (i.e. 8% - 5% = 3%) and your stock portfolio would have outperformed the market.
If the same stock portfolio returned only +4%, when compared to the same market benchmark over the same time horizon, it would have a negative Alpha of -1% (i.e. 4% - 5% = -1%) and your stock portfolio would have underperformed relative to the market.
Tracking your alpha is a simple and effective way for an investor to measure relative performance, and goes to the heart of answering that very important question: am I adding value, or simply wasting my time?
Did you know?
Legendary investor Warren Buffet believes most investors would achieve better returns by investing in an index fund as opposed to trying to beat the market. He believes that any active return fund managers make will eventually be eroded by fees. Research from S&P and Dow Jones indices supports Buffet’s thinking. Data revealed that active investors who outperform against a benchmark over a one-year period have a less than 50% chance of outperforming it again by the same rate in the second year. The study also found that, even if investors had a successful three-year record of generating active returns, they underperformed the benchmark in the following three years.
At BullsEye Investors we believe strongly that intelligent investing requires active monitoring of the performance of your investments, and basing buy and sell trading decisions on facts, using tried and tested technical and performance-related indicators to inform, rather than listening to self-appointed social media experts or chat forum trolls.
That is why we view alpha as a key indicator, one which all investors should track no matter whether you are novice or seasoned pro.
It is also why we have built the BullsEye app to allow users to measure their alpha over varying time horizons against established international market benchmarks - such as the FTSE 100, S&P 500, EuroStoxx 50, Nifty 50, HangSeng and many more.
Things to consider
All investors believe their stock choices will deliver superior returns, beyond the returns produced by adopting a passive investment strategy.
While alpha is seen as the holy grail of investing, particularly for those professional investors who build their reputation on an ability to consistently outperform the markets, like many things it is only useful when applied in the correct context.
There are two seemingly obvious, but very important considerations to take into account when analysing your alpha.
Choose the right context
A basic calculation of alpha subtracts the total return of an investment or portfolio of investments from a comparable stock market benchmark in its category. Therefore, for useful comparisons to be made it is important that you get the context correct and use an appropriate market benchmark.
Appropriate can mean different things to different people - but generally this means using a comparative market benchmark that is the same or similar to the market or sector of the stock being monitored.
You know what they say about comparing apples and oranges!
Other than context, the second critical dimension of any alpha calculation is time. Over what time horizon are you comparing your investment's performance?
Although Warren Buffet may believe that most stock market investors would achieve better returns by adopting a passive investment strategy and investing in an index fund, as opposed to trying to beat the market, he also famously said:
"The stock market is a device for transferring money from the impatient to the patient."
Do not lose faith if your alpha is negative in the short-term.
Similarly, it does not mean you are an investing super-deity if you manage to return a positive alpha over the same time period.
Take a balanced approach and overlay your unique circumstances and the wider stock market conditions to the result.
Alpha is one of the key tools at your disposal to make informed investing decisions, but not the be-all-and-end-all.