Per Investopedia – “Alpha (α) is a term used in investing to describe an investment strategy’s ability to beat the market, or its “edge.” Alpha is thus also often referred to as “excess return” or “abnormal rate of return,” which refers to the idea that markets are efficient, and so there is no way to systematically earn returns that exceed the broad market as a whole.”
We’ll try to make that the most technical part of today’s conversation… Simply put, your return is the market return plus (or minus) alpha. One can achieve alpha by taking on more risk than the market, or most commonly, knowing something that the market doesn’t. At least that used to be the case. Today, information travels instantaneously and markets react in milliseconds to any news that comes out, good or bad.
Historically, alpha, or an investors’ edge, was determined by what they knew that others did not. Did you uncover a hidden economic relationship or intel on a new product that the market doesn’t understand? You can gain alpha by placing an investment to exploit that knowledge advantage. Let’s rewind to pre-email, pre-twitter days where market research reports were faxed around Wall Street. If you got the report first, you had more time to interpret the research and make an informed decision. Easy – do what you can to get the reports first. Well, that’s what some hedge funds did, going so far as naming your firm alphabetically first to get reports first (cough, David Tepper, cough, Appaloosa Management, cough).
Enter the age of the internet – information is widely known and immediately priced into current stock values. If we can’t get an edge and gain alpha by knowing what others don’t, we must interpret news and data differently. We stress this often, but we believe investing in high quality companies with stable cash flows at reasonable valuations is key to long term success. Avoiding fad or “story” stocks and common investor pitfalls like being greedy or fearful at the wrong time can also be important. Patience is the second key to obtaining alpha in today’s digital age. Numerous studies in behavioral finance suggest that patience is key to good returns. Patience is easy when the market is going up but having the gumption to stick with your strategy during the tough times is even more important. Afterall, some of the best days in the market often come right after some of the worst days in the market.
Just think, how often have you wanted to sell a stock when it’s down and wished you bought more after the stock goes up? Having an advisor, or coach, to check your emotions before making tough decisions can be a key part of making sure you act rationally and achieve good results.