The Science Of Investing And The Evolving Definition Of Alpha

Aug. 21, 2013 1:16 PM ETTILT, MMTM, TLTD, TLTE36 Comments
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By Samuel Lee

Though it sometimes is hijacked by ideologues, the scientific method works. The most successful societies entrust scientifically trained workers with the most specialized tasks, such as performing brain surgery, designing airplanes, and setting marketwide interest rates. And yet, many individuals regularly entrust their fortunes to the investing equivalents of witch doctors and astrologers. Or they take matters into their own hands for no good reason other than a vague belief that they can do it if they put their minds to it. Unlike good scientists, they're not skeptical enough of themselves or others.

Brains and education are no panacea. My father is a tenured professor of electrical engineering at one of South Korea's top research universities. When he designs a microchip, he draws on his years of education, consults industry journals, and relies heavily on the work of other engineers. When he speculates in small-cap technology stocks, his efforts are far more casual and sometimes include asking me which ones I like--I always profess ignorance. Despite admittedly subpar performance over 20-something years of investing, he refuses to give up control and index his holdings. It's as if the logical, skeptical part of his brain shuts down, and a more animal, overconfident part of his brain takes over in all matters investing. Would I, armed with nothing more than the efforts of a few spare hours each week, go into the chip-design business to compete with the likes of Intel and ARM? Of course not.

There is a science to investing. Though you may not know them by their technical names, chances are you're familiar with the fruits of Modern Portfolio Theory, the connection between risk and return, the theory of interest, and the efficient market hypothesis. Parts of financial theory are so integral to the practice of investing that most investors have forgotten

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