Most Investors Should Just Forget About Alpha

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.

Disregarding alpha

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.

Recommended Articles

5 Franchises You Can Buy for Less Than $80K

A convenient way to start a business is through a franchise. There is an already built-in business model, consumer base, and operational supply chain. However, if you join a globally-known

How to Encourage Loved Ones to Adopt Healthy Eating

It’s painful to watch loved ones suffering with chronic health problems, such as food intolerances, headaches, allergies, digestive pain and menstrual issues. We wish there was something we could do

How to Retire 15 Years from Today

Retirement planning should ideally begin from the day you have your first job. However, even if you have made no special financial preparations for your retirement, you could still start

The Cost of Owning a Pet Can Be Surprising, So Plan Ahead

A cat or dog can be cute, cuddly, and great for companionship. Yet the cost of owning a pet can be surprising. Pets are living beings that must be taken

Dump Growth Stocks for Value? Market Weighing Options

In this article I make a brief comparison of growth stocks versus value stocks, a topic often addressed by the mainstream financial media.Growth stocks typically offer a substantially higher growth

7 Countries Where You’ll Find Bugs On the Menu

Creepy, crawly, gross, slimy. There are several ways to describe bugs, but here in the United States, few of us would use the words “delicious” or “yummy” when talking about

Get Rich Slowly with a Slick Dividend Reinvestment Strategy

The time-tested wisdom from leading value investors has always been that if you want to make money in the stock market, invest in high quality stocks and do not sell

A Surprising Way to Get Health Benefits from Coffee

You may have heard of green coffee bean extract for weight loss, but this potent natural remedy offers other important benefits, too. Read on to discover how green coffee bean

4 Ways to Make Extra Cash Using Your Car

Owning a car does not necessarily have to be an expensive proposition. While you cannot avoid paying the auto loan installments or the car insurance and maintenance costs, you can

Paid Not to Work: How Universal Basic Income Might Compensate for Coming Job Losses

The unemployment rate for the United States represents only the amount of people who are unemployed and also actively looking for work. Separately, the workforce participation rate includes Americans were unemployed

Meet the People Who Built or Inherited Fortunes — Then Lost It All

It’s amazing how much money rules our lives. The average person will barely make $1 million over the course of a working lifetime. Meanwhile, in the United States and all

Luxury Used Cars You Can Buy Cheap and Almost New

Looking for a luxury used car you can buy cheap? Careful what you wish for. First-time owners of luxury vehicles don’t always appreciate maintenance and repair costs. Uninformed buyers may