Beating The Market or Beating Your Neighbour

The one equation that explains how this game works

I am not referring to beating up your neighbour; I am using it in the context of investment performance. What you are about to witness is my attempt at explaining how this game works.

Let's start with the basic, which is the fundamental regression equation of modern portfolio management:

R = 𝞪 + 𝝱 + 𝞮

It is pronounced as Investment Return is a factor of Alpha plus Beta plus Epsilon. 

Stay with me for a while more; I promised to make things clearer. I am not trying to impress upon you my mathematical ability. What you just saw is the fundamental regression equation of modern portfolio management.

R, the return of a security is equal to its idiosyncratic factors (alpha)(𝞪) plus its co-movement with relevant market indices (beta)(𝝱) plus everything else (epsilon)( 𝞮).

The language spoken by professional investors is dominated by this simple econometric formulation.

Often, we ask questions concerning whether an investment strategy work? How does an investment strategy work? What works in the market? These questions can all be framed entirely in terms of alpha and beta, even if these words are not used explicitly. 

When investors ask a portfolio manager "what is your edge?", they are asking about the set of alpha factors that can differentiate the performance of an actively managed portfolio from a passively managed portfolio. 

In this article, we will talk about beating the market, i.e. Alpha 𝞪.

First thing you would want to know about 𝞪 is that it stands for excess return.

It is the excess return over and above the market rate of return. A financial professional will have no trouble understanding this. It is about the three most important words in portfolio management - beating the market. 

There are different schools of market players out there who claim to be able to beat the market. Many have tried, and many more will attempt each day, but most will fail to beat the market. There is nothing cynical about the underperformance of active managers. That's a permanent condition and has been so for a long time. Every year, the S&P Dow Jones Indices Versus Active (SPIVA) scorecards demonstrate that the majority—in most cases a very large majority—of active managers underperform their appropriate risk-adjusted benchmarks in every asset class.

And even though the evidence is overwhelming, many (including you who is reading this right now) have every intention to tried to do so. 

The second thing you would want to know about 𝞪 is what is possible and what is not?

One of the most important concepts in 𝞪 for a beginning investor to understand is what is possible and what is not.

Which begs the question that I often ask my audiences when I speak - how much of a return in terms of percentages does a good investor make?

Many novice investors are sold on the idea that you can achieve gravity-defying numbers with very little efforts. There is a thriving industry of charlatans who sell anything from a newsletter to special systems and mentoring programs, all claiming that your millionaire dream is possible with very little effort and risk. They all told amazing stories of how they made it and managed to figure out a secret method, that apparently only they knew, and they have somehow found that it was their passion to teach them to you.

Given how motivated most beginning investors are in learning the trick of the trade, I am not surprised that many have forked out a fortune to attend such programs with nothing to show for it.

Let's put things in perspective. If you think that it is possible to achieve 30%, 50% or even 100% in investment, I can say that you are definitely delusional. The very best in the field--the likes of Buffett, Graham, Munger, Druckenmiller, Soros, Greenblatt-- these humans, the best of the best, they produce an average of about 20% p.a. 

If you manage to produce 30% in a single year, that is entirely possible. Once in a while, Lady Luck can smile at you. But to expect to achieve that year in year out is really asking for the sky.

Still not convince? We can put this hypothesis to the test. Suppose the Guru told you that their track record from their system is 30%. Let's say you start off with $10,000. Using the rule of 72, in 2.4 years you would have double your money to $20,000. In 4.8 years, you would have $40,000. It may appear slow at first, and that is because you are starting from a low base. But in 16 years, you would be a millionaire—$ 5 million in 21 years and a billionaire in 43 years. If you live a long life, like Mr Buffett does, and compound money like he does, you are almost destined to be a billionaire someday. 

By the way, 30% p.a. claims is not the worst I have seen. I received in my email inbox this trader that managed to turn $1000 into $2 million in 2 years. That works out to be 4,372%. That is like promising you that you can become a billionaire in exactly three years using his trading system.

Your 𝞪 do not have to be 30% or 100%

The thing is that your 𝞪 need not have to be in the range of 30% to 100% for you to be a successful investor. You don't even have to achieve 20%. If you can achieve a consistent 5%, 10% or even 15%, you will be considered a successful investor. The keyword here is consistent. 

But being consistent is not easy to do in investing. It takes time and effort. Most day traders lose money. That is one of the many dirty little secrets that your investment advisor does not want you to know. Studies from different time periods have consistently proven this. The speculating crowd usually amass a bit of a profit during bull market, only to give back much more when the market turns. In fact, I would even state out front that it is a minus-sum game in which the losses of the majority flow into the pockets of a savvy and disciplined minority. If you trade and expect to earn a secondary stream of consistent income from doing that. The odds are against you. 

But it is not impossible. Just like someone will eventually win a gold medal in the Olympics. The first step is to learn about Rule #1. (More about that in a while)

Now let's turn our attention to the second part of the equation — Beta - Getting the market return — and beating your neighbour.

Beating Your Neighbour