How would you like to have an “edge” in the stock market? The vast majority of investors would love to find one, of course, and many constantly seek advantages to exploit.
We are led, however, to believe that markets are efficient. This means that the price of stocks is determined by the current information available.
With efficient markets, everyone has access to all information at any given moment. This implies that no market edge is even possible.
Yet money managers hang their hats on discovering that elusive “alpha” — the edge that may or may not exist.
So what is alpha?
Alpha measures the excess return over a market benchmark within a specific period. Often, this benchmark is the S&P 500, but not always.
Alpha is used extensively on Wall Street to track the performance of money managers. Their bonuses reflect their ability to boost alpha, that is, to consistently exceed the overall market.
But is alpha a useful measure for retail investors? After all, alpha is not standardized and is not the only measure of investment success.
The common approach to applying alpha is to use it as part of the capital asset pricing model (CAPM). This is the model applied to efficient markets. It is a linear equation that considers the risk-free rate, the beta (risk) of a stock or fund and the expected market return of a benchmark.
The trickiest aspect of this CAPM is the expected market return. This is based on assumptions that may or may not be valid.
Many investors believe that the returns in the stock market revert to the mean. This suggests that funds or stocks that beat a benchmark over the long term will not continue to do so. If you accept the mean-reversion hypothesis, alpha is only useful in the short term.
It’s also important to know what benchmark is applied as part of the measure. When investment managers advertise that their products beat “the market” they could be referring to obscure benchmarks in order to skew this figure.
When comparing two funds using alpha, make sure the benchmark used is the same for each.
If you are an active trader or plan to be, you may find alpha a useful measure. However, most retail investors should not worry about alpha. If you hold the belief that the stock market is mean-reverting, then your best course of action is to invest in the benchmark.
The S&P 500 is a common benchmark used by investors and is tracked by third-party data providers. A portfolio based on the S&P 500 offers a well-diversified selection of large U.S. stocks. That diversification lowers the risk, which explains the popularity of the index.
You have a few choices when investing in this and other indices. If you decide to invest in an index mutual fund of the S&P 500, for instance, you can select from companies such as Vanguard, State Street, Fidelity and BlackRock, among others.
You can boost your returns further by investing in an index exchange-traded fund (ETF) of the S&P 500. These funds often charge lower fees than their index fund and mutual fund counterparts.
Another way to boost your returns is to consider dividend-paying stocks on stable companies. The debate rages as to whether dividends outperform growth stocks. Growth investors will claim that the returns on growth stocks can exceed the total return of dividend stocks by a wide margin.
Selection is an issue, however. While dividend payers are usually stable over time, many growth stocks never live up to their potential. That is why some investors enjoy the steady income offered by safer stocks that have a history of consistently increasing their dividends.