Human Alpha vs. Portfolio Alpha

August 02, 2010

By Ray Padrón, CPA, CFP®, CIMA®, PFS 

Many view the future economic path as anything but predictable. The very governments that people were yelling at to save them from financial oblivion are now the problem, as legislators struggle to find the best path for economic prosperity. To many investors, risk appears to be all over the place, and many keep wondering if “this time really is different?”

So how does one make good decisions about investing for their future in the middle of uncertain circumstances? The answer is not found in investment theory or Capital Asset Pricing Models, technical risk ratios or efficiently designed portfolios. While we factor those fundamentals into Brightworth portfolios, the true answer to long-term investment success is in finding alpha, the kind I am affectionately going to call “human alpha.”

In the financial world, “investment alpha” is a positive attribute we look to build into portfolios by finding the best active money managers in their respective space or strategy. What each of these managers strives to provide is excess return for the same or lower level of risk (or volatility) as their benchmark. This excess return is called “alpha.” Positive investment alpha tells us that the manager is adding value over and above the index. Unfortunately most investors don’t know how to take advantage of this alpha because they don’t have enough “human alpha.” A recent Bloomberg study indicated that over two-thirds of investors have not seen their portfolio go up since the market bottom in March 2009. If that surprises you, the figures are even more remarkable over the last 20 years. For the period ending December 31, 2008, the average investor made only 1.9% per year on their investments during a period when the S&P 500 returned 8.4%, fixed income returned 7.4% and inflation was 2.8%!¹

Given these facts, it is apparent that the average investor has negative human alpha. They become their own roadblock in the path to financial prosperity. During the 2008 market meltdown most investors ran for “safety,” living and investing in what many describe as a bunker mentality. What those investors still may not realize is that they didn’t build a bunker for themselves, they built a tomb. By not participating in the positive (post emotional) recovery that has taken place since March of 2009, capital has been permanently lost. The bunker mentality prevents most investors from taking advantage of what the market has to offer in the long run, let alone the potential for investment alpha.

Most behavioral investment specialists explain the reason for the discrepancy between the average investor returns and the market returns comes from a set of beliefs that are wrong. And, because our emotions are our primary drivers, that mentality is very hard to overcome. Typical negative alpha behaviors include performance chasing, speculative euphoria at market tops or panicky capitulations at bottoms. So how does one make sure they not only have investment alpha but much more importantly the “human alpha” to take advantage of it? The answer is DISCIPLINE. In this case discipline is a decision to keep doing the right things. It is saying and believing “I won’t get caught up in what’s working this very second; I care about what has worked in the past, and I am going to persist in doing the things that have, most reliably, always worked.”²

At Brightworth, bringing excellence to our clients’ wealth strategy is at the core of who we are. A disciplined approach in the development and execution of that strategy is a key factor in achieving success. Our disciplined approach includes three key elements:

• Strategic Portfolio Management in light of time horizons, volatility, taxes and inflation.
• Liquid Cash Reserves that provide short-term certainty and a cushion to draw from during volatile periods.
• Integrating A Prudent Withdrawal Rate both in your capital accumulation and spending decisions so your portfolio can go the distance.

“Human alpha” is not easy to develop or maintain, and by our observation is more impactful than portfolio alpha. That is why our clients have chosen to delegate that discipline to us, and to be coached during the times when it seems hardest to maintain. The most successful investors are those that apply a consistent approach to investing, incorporating principles that have reliably worked, and have the determination to see their wealth strategy through. This allows you, our client, to live your life and enjoy the journey.

¹ JP Morgan Asset Management and DALBAR, Inc.
² Nick Murray, Behavioral Investment Counseling, 2008.