Monday, January 22, 2018

The Incredible Shrinking Alpha

Over the decades it’s been getting harder to beat the average returns of purely mechanical investment strategies according to Larry Swedroe and Andrew Berkin in their book, The Incredible Shrinking Alpha. Looking for superior stocks may have been profitable many years ago for intelligent investors with the right temperament, but even the most brilliant money managers today usually fail to beat the markets.

In this short book, the authors go through their reasons for why markets have been getting tougher: there is less “dumb” money to exploit, the market is being “overgrazed,” and “the level of competition is getting ever tougher as better data and technology are used by ever more skilled managers.” Then they go on to give their prescription for how you should invest your money.

In the article Measuring Stock-Picking Skill, I explained the meanings of the terms alpha and beta in this context, and why I don’t fully agree with the authors when they try to prove that past successful investors didn’t have stock-picking skill. I won’t repeat this here.

To beat the market, you actually have to outperform other investors. To buy a stock that is cheap, you have to buy it from someone who is foolishly selling the stock at too low a price. So, if it were easy to beat the market there would have to be a large pool of terrible investors giving away their money. However, “there has been a substantial downward trend in the fraction of U.S. equity owned directly by individuals.” As time has passed, more and more assets have been controlled and invested by professionals.

Passive investors may get higher returns than the average active investor, but “Active managers play an important societal role—their actions determine security prices, which in turn determine how capital is allocated.” “Passive investors are ‘free riders.’” So, active investors benefit us all, but end up with lower returns, on average, for their trouble.

One of the reasons why alpha is hard to find is that “Alpha is a finite resource” and there are many brilliant professionals chasing their share. The authors’ prescription for how individual investors should handle their savings is diversify, invest in passive funds, and keep costs low.

I think this book is worth a read, especially for those who try to pick their own stocks. You should either convince yourself that the authors’ arguments don’t apply to you (I know they apply to me) or invest in indexes.


  1. While I generally agree, the way "the market" is defined may be too simplistic.

    If you define investable assets as the ones that everyone is paying attention to, then it naturally follows that everyone is paying attention to them.

    However that leaves out anything that investors (professional or otherwise) have decided is too hard to understand, too small, or too hard to access.

    These could be unpredictable businesses, smaller stocks that don't have a total potential large enough for active fund managers, or foreign countries where it's difficult to get access through a broker.

    Of course they do have risks. But I don't think anyone is claiming alpha has to be risk-free.

    The one rule that is more true than ever is that having more assets makes it harder to find good opportunities. It seems that individual investors would have one advantage over fund managers there.

    On a side note it would be really interesting to see whether the decline in individual investors is mostly due to a transition to index funds.

    1. @Richard: Swedroe has written many times about how active stock-pickers fare in more difficult markets, such as very small stocks or foreign stocks. The answer, invariably, is not too well on average.

      As a whole, investors with less assets don't have an advantage. It's only investors with the skill to produce alpha who are better off investing smaller sums. So, for the thundering herd, a smaller portfolio doesn't help.

      As I understand it, the decline in individual investors came initially from people shifting into mutual funds instead of picking their own stocks. The rise of ETFs has mostly taken assets away from mutual funds that are "closet index funds" charging high fees.

    2. They do have an advantage but like a 15-year old who got a car for their birthday it doesn't mean they can use it :)

      I may have seen some of those articles. I believe they relied on indexes to show the natural result that an index will give the average of the performance in the market it covers -- so it's still impossible for the average in that market to be better than the index.

      I would still expect that if there is an opportunity to outperform it's most likely to be at the extremes. There are stocks so small that they aren't in any index. There are countries that individual investors can only access by opening a brokerage account with a firm in Hong Kong (blocking out many small investors), where some stocks are too small to be worth the trouble for medium- to large-scale investors (blocking out all professional managers).

      Is the nearest available index an adequate stand-in? Maybe, but at some point there are too many indexes to call it a passive choice.

      That doesn't mean in any way that everyone can outperform the market. But it doesn't always come down to having the most research or assets.

      Disciplined decisions are a challenge for both amateur and professional investors. Being able to say "no" to something that's almost good enough but not quite, or something that seems very urgent and contradicts your long-term strategy, may be the most important factor in getting better performance.

      The market does seem to reliably transfer wealth from the less disciplined to the more disciplined whether that's in sticking to an allocation of index funds or picking stocks.