Uncover The Source Of Your Negative Alpha

by: Ralph Wakerly
Summary

Identifying the source of “negative alpha” in your investing is just as important as crafting a sound investment strategy and approach.

My story of ill-advised market timing illustrates an example of generating negative alpha.

It can be difficult to break bad investing habits, even if you have advanced investing knowledge and skill.

I recommend performing a thorough analysis of your historical investment decision making and implementing effective behavioral mechanisms to help you prevent recurring mistakes.

Editor's note: Seeking Alpha is proud to welcome Ralph Wakerly as a new contributor. It's easy to become a Seeking Alpha contributor and earn money for your best investment ideas. Active contributors also get free access to the SA PRO archive. Click here to find out more »

What is your source of "negative alpha?" In other words, what recurring actions do you take that reduce the return you should have generated?

If you are on this forum, you are undoubtedly an advanced investor. You have a portfolio strategy. You understand finance and how the markets work, and and you have deep investing knowledge.

But do you know where you have created negative alpha in your investment decision making? How well do you know yourself? If you are honest and have carefully evaluated your performance, you will likely uncover times when your portfolio has underperformed a benchmark with similar risk-return characteristics. Why did that happen? Are there systemic reasons?

I suspect many of the reasons are behavioral. You can have an investing IQ of 160, but at times you might behave counter to your own investing wisdom, knowledge, or philosophy. I know - I've done this myself.

I believe self-analysis can be more valuable than choosing the right investment portfolio management approach or the best securities, particularly for an advanced investor.

Investing is not a game where the guy with the 160 IQ beats the guy with the 130 IQ. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing. - Warren Buffet

My Story

I'm going to share a sobering analysis from my own investing history to demonstrate this concept. To provide some perspective, here is a little bit about me:

  • 35+ years of investing experience
  • Manager or advisor for portfolios totaling eight digits
  • More than 11,000 hours of research on investing and personal finance
  • Utilize a passive investing approach with index funds across major asset classes. I describe my approach in detail here.
  • MBA in Investments and Industrial Engineer, University of Illinois Urbana-Champaign
  • Consultant, Entrepreneur and Investor

Uncovering My Negative Alpha

Let's discuss one of my recurring mistakes which likely did the most damage to my long-term investment performance. While completing my MBA, I learned how to forecast the stock market valuation for the coming year using the Gordon Model.

The table below depicts the results of my forecasts compared to the market's actual performance. Back then, I used the S&P 400 index. At the time, this was a subset of the 500, sans the 40 utilities, 40 financials and 20 transportation stocks, which had better data to support my research.

Stock Market Forecast vs. Actual Returns

Year

Model Forecast Return

S&P 400 Index

Actual Return

S&P 400 Index*

1981

-12.8%

-11.2%

1982

18.2%

15.0%

1983

19.8%

18.5%

1984

-2.0%

0.0%

1985

13.8%

25.9%

1986

-16.0%

15.1%

1987

18.8%

6.5%

1988

1.5%

16.6%

*Total return including dividends. 1988 shows S&P 500 return.

By 1985, I was feeling pretty confident in my approach. I assumed I could use market timing to achieve superior returns. Near the end of 1985, my 1986 forecast indicated a market return of -16%. Based on that false sense of investment acumen, I went into 1986 holding only 15% of my portfolio in equities. Those were held in actively managed mutual funds, which performed roughly in the upper-middle of the pack at the time. Bonds and cash made up the rest of my portfolio.

My portfolio earned 5.6% versus 18.5% for the S&P 500 index in 1986. I didn't lose money, but I missed out on significant gains.

Then came the infamous 1987 crash. Using my forecast, albeit without full conviction, I was back at 58% equities going into that fateful October day, when the market dropped by more than 22%. My portfolio plummeted, although my losses were less significant than those of many others who were fully invested in equities.

Instead of buying back in after the drop to rebalance my holdings, I sold. The result for 1987: I earned -0.3% versus 5.2% for the S&P 500 index. As the sage Sir John Templeton advised on the venerable Wall Street Week show, right after the drop, it was time to buy.

I know now that I made the wrong choice by retaining my underweight equity position going into 1988. My forecast for that year was a market gain of only 1.5%. Believing in this "expert knowledge," and still feeling shaken after the crash, I decided to hold a moderate 50% equity allocation in a low-beta, defensive fund. I put 45% in long term bonds and 5% in gold. The result for 1988? My portfolio earned 6.7% versus 16.6% for the S&P 500.

At my young age and in the early stages of my career, I should have been closer to 100% in equities. The cumulative returns for the S&P 500 for 1986-1988 were 45.3% versus my portfolio return of 12.3%. That is a significant difference, but it is even more painful to evaluate it in terms of dollars then and now.

Let's say I had a $100,000 portfolio at the beginning of 1986. At the end of 1988, I would have had $123,400, not bad at all. However, had I been 100% committed to equities in an S&P 500 index fund, I would have had $145,368.

Even worse - or better, depending on your point of view - had I invested the $22K differential in the S&P 500, I would have had an extra $387,163 by the end of 2017! Now that's what I call negative alpha!

My overconfidence and belief in my ability to time the market via superior analysis turned out to be a critical mistake. I compounded this error by making an emotional sell decision after a market drop, leading to the negative alpha.

But the next part of my story took a more positive turn. I gave up market timing in 1989 and was fully invested in equities through 1999. That paid off substantially during one of the greatest bull markets in history. I was fortunate to move significant funds out of the market at the 1999 peak, not because of prescient market timing, but because we needed the money to fund our kids' upcoming college expenses.

Old Habits Are Hard to Break!

Fast forward to the 2001-2003 bear market. Long before this I had stopped doing market forecasts. By this time, my allocations had shifted to a more conservative stance, not based on market timing, but based on my risk-return preferences and my overall financial goals. I went in with a 61% equity position, along with my usual smattering of bonds, cash, and some gold. However, when the bear market ensued, I was convinced we were experiencing a longer term economic and market meltdown.

After losing less than the market in 2002 (-16.7% versus -22.1% for the S&P 500), I moved to a 10% equity allocation and bought index put options to further hedge my risk. I sold low. History repeats itself! Predictably, my returns during the 2003-2004 recovery were -0.8% and 5.1% respectively, versus 28.7% and 10.9% for the S&P 500. I won't bother adding up the negative alpha dollar amounts associated with that bad move, but you get the idea.

For what it's worth by the time of the 2008-2009 bear market, I had learned my lesson. While the crash automatically lowered my equity allocation, I didn't manually reduce it even further by selling. However, I also didn't rebalance by buying more equities even though I should have. Old habits really do die hard!

What I Learned the Hard Way

My key takeaways from these experiences are as follows:

Market timing is problematic at best. It is very difficult to profit from market timing. In his book Asset Allocation, Roger Gibson cites research indicating that for market timing to pay, investors must predict the market correctly at least:

  • 80% of the time for bull markets and 50% for bear markets, or
  • 70% of the time for bull markets and 80% for bear markets, or
  • 60% for bull markets and 90% for bear markets

In the book Investment Policy, Charles D. Ellis cites a study of 100 pension funds that indicated: "...their experience with market timing found that while all the funds had engaged in at least some market timing, not one of the funds had improved its rate of return. In fact, 89 of the 100 lost as a result of timing and their losses averaged a daunting 4.5% over the five-year period."

There are many more compelling pieces on the difficulty of market timing, for example:

Don't be overconfident. After a few years of success with my market forecasting system, I had a false sense of confidence. How could I expect to do what 89 pension funds couldn't do, even with hordes of analysts and deep pockets for investment research? Realize that no matter how much you know or how much homework you've done, the market will humble you. Don't bet too much of your portfolio on any one investing idea because you think you are smarter.

Realize that your brain is wired to repeat the same investing mistakes. In his excellent book Your Money And Your Brain, Jason Zweig sums it up nicely: "Knowing the right answer and doing the right thing, are very different." Zweig describes how the ancient biological wiring of our brain influences our investment decision-making and offers methods to manage this.

Don't follow the crowd or act on emotion. When the market drops 22% in one day (like in 1987), when thousands are killed in a terrorist act (9/11), or when major financial institutions go under (such as the 2008 Lehman Brothers collapse, a precursor to the Great Recession), emotions can take over. The news media paints a picture of the end days. Cold, calculated, rational views are hard to come by - and even harder to follow. Step back and review your long-term investment plan and policy. Time and again, we see the benefits of a long-term investing horizon.

Understand the source of your investing mistakes: your negative alpha. This is the most important lesson I learned. Whether you believe market timing is a mistake or not, each of us makes some type of investing mistake. Analyze your past performance and your investing decisions. Find out which decisions led to underperformance. Identify those mistakes you tend to repeat.

What a Smart Investor Can Do - Uncover and Combat Your Source of Negative Alpha

I believe we can avoid some of our repeated mistakes, provided we utilize effective mechanisms. While I am still working on eradicating my own underlying bad tendencies, I've found that the following tactics can help:

First, understand what types of mistakes are possible. If you don't know what to look for, you can't recognize them in your own investing. In addition to the Zweig book, I strongly recommend the outstanding book by Swedroe and Balaban, "Investment Mistakes Even Smart Investors Make and How to Avoid Them." Also, I've listed my top ten mistakes at Investment Psychology. Examples include not sticking to a long term investment strategy, relying on bad advice from the wrong sources, chasing performance, and being too active by moving in and out of securities and/or asset classes.

Analyze your own performance history and determine which decisions might have led to underperformance. Look at your year by year returns. Look for recurring mistakes. Incidentally, I have found that the average investor doesn't know their portfolio rate of return. They might know the returns for their 401(k) or the returns of assets held at a single brokerage account, but not the returns for their entire portfolio. It is essential to track your overall portfolio returns at least annually, if not more frequently in order to manage a portfolio effectively. It's also concerning that many investors don't have a suitable comparison benchmark to gauge how well they are doing. I mentioned the S&P 500 index above, but that isn't my benchmark, nor should it be for most of us.

Write an Investment Policy Statement (NYSEARCA:IPS) that describes what you should and should not be doing. For example, mine includes a stern and pointed warning to myself: "Therefore we will commit to a target asset allocation range and stay with it for many years. Active trading and significant tactical variation in allocations produces sub-par returns and high costs. We have no solid basis for believing we have superior tactical asset allocation skill. Our research shows even the professionals have failed at this."

Utilize an objective third party to help you follow your policy. This might be your financial advisor, spouse, or a knowledgeable investing colleague whom you trust.

Review your knowledge sources periodically. Revisit insights about common investor mistakes that you've accumulated via books, websites and your personal notes. Review your IPS periodically to keep it top of mind.

I hope this might help you identify your negative alpha and eliminate or at least curtail its causes.

Seek and ye shall find.

I'll close with another piece of Buffet wisdom:

What counts for most people in investing is not how much they know, but rather how realistically they define what they don't know. An investor needs to do very few things right as long as he or she avoids big mistakes.

I look forward to hearing your comments and insights about sources of negative alpha and how to eliminate them.

Good luck and good investing!

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.