In the investing world, alpha refers to the ability to beat the market. In his book The Quest for Alpha, Larry Swedroe argues strongly that persistent alpha is exceedingly rare and we shouldn’t bother to look for it. He says that investors should use index investing to get market returns with minimum cost. In this way we will actually outperform those who try to beat the market.
Swedroe is big on evidence. He looks at the numbers for mutual funds, pension plans, hedge funds, individual investors, and behavioural finance, and concludes that positive alpha is rare over long periods of time.
For investors who think they can beat the market because they are smart, Swedroe has the amusing example of a Mensa investing club that had lost to the market returns by 13% per year for 15 years. “One investor described their strategy as buy low, sell lower.”
David Swensen is quoted as saying “Individuals who attempt to compete with resource-rich money management organizations simply provide fodder for large institutional cannon.” Decades ago, the percentage of trades performed by institutional investors was low, but in recent years it has risen to 80% or 90%. Active individual investors have stiff competition.
In an interesting study of individual investors’ brokerage accounts, the investors overestimated their own performance by 11.6% per year! Most people lost to the market return but had no idea this was true. It seems that investors would rather protect their egos than their money.
Swedroe accuses both Wall Street and the media of knowing that individual investors can’t beat the market, but brokers make money from helping investors try to beat the market, and media stories about index investing are too boring to bring in readers.
Swedroe offers 30 “prudent rules of investing”. Here are three of them:
“Before acting on seemingly valuable information, ask yourself why you believe that information is not already incorporated into prices.”
“Never work with a commission-based advisor.”
“Keep a diary of your predictions about the market. After a while, you will conclude that you should not act on your ‘insights.’”
When asked about Warren Buffett, Swedroe says that if you see Buffett when you look in the mirror, “go ahead and seek the Holy Grail of alpha.” If not he says you should “play the winner’s game,” meaning low-cost indexing.
The final quote of the book is from Buffett who says that “the stock market serves as a relocation center at which money is moved from the active to the passive.”
Investors who seek alpha for their own investments should read this book and either give up the quest or explain to themselves why Swedroe’s arguments don’t apply to them.