Alpha Might Be Bigfoot, but I'm Going to Hunt It Anyway
Skill is likely to persist, but luck is ephemeral
As a child, I had a piggy bank with $20 of spare change in it. I loved to dump it onto the floor and count it. I called it “playing with money.”
So when it came time to choose a major in college, it was no surprise that I chose “playing with money” as my major. In other words, I chose finance.
Our campus investment club held a weekly career series. Finance professionals from different local companies came to share their advice. They shared what a typical day in their job looked like. Then, they pitched their company as a great place to work.
Investment bankers came to speak at our college. They told us that investment banking is the most lucrative career we could choose. They told us that the only 22-year-olds who earn more are famous celebrities and pro athletes. Naturally, I was sold.
In college, we learned how to build a discounted cash flow model (“DCF”). We learned that this was the best method for determining the value of a company. Professors endorsed it as the most scientific method.
Fast forward to my first day working on Wall Street. We were kicking off the roadshow for an IPO. A pitch deck was on my desk, along with instructions to memorize it inside out. Imagine my horror as I flipped through the pitch deck and found not a discounted cash flow model in sight.
I would listen in on calls between the trading desk and hedge fund managers. The only topic up for debate is what multiple a company deserves. Multiples are much simpler than the complex financial models I had trained to build. I pondered how divorced the price of these stocks may be from their intrinsic value.
Of course, the biggest problem with DCFs is that the answer they spit out is only as good as the inputs that go in. Garbage in, garbage out. The same is true of large language models like ChatGPT.
When I was in college, I came across research that almost ended my career before it even started. It was about alpha. Alpha is the return you make above and beyond what the market gives you. If the market returns 5% and your portfolio returns 7%, then your alpha is 2%. (I’ve always thought consistently underperforming the market is its own unique skill. Perhaps that should get its own Greek letter too. I like to call it “omega.”)
The research found that when an investment manager beats the market one year, there’s a 50% chance he’ll beat the market next year. He has no better probability than a coin flip. Meaning, there is no such thing as skill in investing. There’s only luck.
Over any long stretch, almost no one beats the market. (Not even Warren Buffet -- more on that next week).
In 2021, 20.1% of large-cap funds in the top quartile stayed there in 2022. By 2023, that number dropped to 0.0%. In more than 15 years, about 90% of professional managers did worse than their index.
So Alpha is like Bigfoot. Have there been any confirmed sightings? Everyone has a cousin who saw him, but nobody has a clear photo.
So if it’s mostly luck, and not even the top professionals can beat a plain index fund, then why not just buy the S&P 500, close your laptop, and go outside?
The closer I got to Wall Street, the worse the picture became. I saw how wide the gap is between regular people who invest and professional investors. Most regular people who invest underestimate:
The sheer time it takes to cover one stock properly. It’s a full-time job for a team of analysts, and then some. You can’t follow just one company; you also need to track its public and private competitors
The depth of expertise the analysts have. i.e., most biotech stock analysts I know have PhDs in specialties of science I didn’t even know existed
The information gap, which is huge. Professional investors sit down face-to-face with the CEOs. Regulations prevent those CEOs from sharing anything they haven’t already made public. But there are no regulations around body language. Communication gets conveyed. If those meetings were worthless, they wouldn’t keep happening.
Markets are efficient. Pretty dang efficient, from where I was sitting. By the time you read an article about a company, whatever it says is already reflected in the stock price.
In 2022, I bought every quantum computing company that was publicly traded. I had a long-term thesis on the technology and planned to hold them for 20 years. (Patience is my investing strong suit.)
My thesis was wrong. It didn’t take 20 years; it took three. The quantum stocks I held had run up 50x by 2025. The valuations made me nauseous.
The market was wrong both times. The stocks were priced for dead when I bought them. And when I sold, they had priced in a future that hadn’t remotely shown up yet. Markets may be efficient, but they aren’t always rational. They will go from ignoring a sector to obsessing over it, and then back again. This is also how I made 34x I made on a dying crypto miner that everyone else had written off.
I’ve beaten the market plenty of times through a combination of skill and chance. Some of it is that I’ve picked good hunting grounds.
A good hunting ground is the patch of the market that fits the game you’re actually playing. I have a long time frame and can wait for years without seeing action. So, I seek out emerging technologies that have the potential to make a significant impact in the future. I wasn’t buying Coca-Cola. Those are good grounds, and suitable for somebody else.
Here’s why I keep saying this: don’t get investing advice from someone who doesn’t know your situation. There are no perfect investments, only those that fit your risk tolerance, time horizon, and goals better or worse. The best hunting ground for me might be the worst for you. No one can know what you need unless they understand your goals and limits.
Here’s why I keep at it despite everything above. The stock market is one of the few places you can access limited downside and unlimited upside at the same time. You can only lose what you put in. The wealthiest people already understand this. For a middle-class family, housing and pension accounts make up about 80% of their net worth. Stocks make up only 4%. For the richest 1%, their primary residence is a mere 7.6% of assets. Pouring your whole net worth into the house you live in is a middle-class move. The rich hold businesses and stocks, ownership of things that compound without them. You can argue chicken or egg about which came first. The association is too strong to wave away.
So should you try to pick stocks? For most people, no. Buy the index, automate it, and don’t spend your weekends on this.
But if you’re going to do it anyway, and some of us are, here’s what you should know. The edge is real, and it’s not for sale. An AI chatbot hands you the consensus. It doesn’t have information the market doesn’t already know or suspect. To find significant mispricings, you need to know something the market doesn’t or believe something it hasn’t yet accepted. More on how I find these spots every week. Subscribe to follow along.