The Root Cause of Poor Investment Performance
- July 2, 2018
- Posted by: Trendlab Academy
- Category: Knowledge
The root cause of poor investment performance
Imagine they give you $50,000 to take part in a tennis competition with a top tennis professional whereby you have the following options to choose:
Option A: You can choose to play a full match against that pro. For that you need to pay the organizers $10,000 – regardless of the outcome. The match prize is $20,000 but works like a bet. If you win the match, you receive $20,000. If you lose the match, you lose $20,000.
Option B: You can choose to settle for a draw. In this case you don’t lose or win anything and you also don’t have to pay the $10,000 to the organizers.
Which option would you choose?
People usually chose option B because they know they don’t stand a chance to beat a pro and they are rational enough not to pay some organizers to play a game they will lose in all likelihood.
When it comes to investing, you are facing a similar situation. Yet, almost all the people we know choose option A.
To understand why rational people chose an irrational option in investing, let’s see how these options present themselves in the investing arena.
The $50,000 you receive is called Beta1. It represents the wealth produced by our economy that is paid to savers (owners of capital) 2. In other words, it’s the starting prize for participating in the investment game.
The $10,000 that you pay – regardless of the outcome – to have a match with the top professional represents your Costs (transaction costs and ‘advisory’ fees). It is what you pay the financial industry for the ‘privilege’ to play against the top professionals.
The $20,000 prize is called Alpha and it is the extra return you get if you outperform investment professionals or it’s a loss if you underperform them. Positive Alpha and Negative Alpha always add up to zero.
When you invest, you have the choice to stick to Beta strategies (option B) that do not carry extra costs and do not give you chances to win or lose against a professional or you can go for Alpha strategies (option A).
The problem is that people fail to identify the strategies for what they are. This is why they end up with option A. This lack of awareness is the root cause of their poor investment performance.
This framework that identifies investment strategies in essence is what we call the ABC of investing. It’s a simple yet powerful framework which guides you towards the right investment strategy:
- Draw the Alpha game. Don’t think you can easily outsmart the top professionals because ultimately they will be the one outsmarting you;
- Receive the Beta you are entitled to and chose the one that suits your risk profile;
- Minimize your Costs. Be wary of paying for Alpha.
- This is a definition commonly used by finance practitioners (Beta is the return of an asset class), not to be confused with the definition used by the CAPM of portfolio risk, (the covariance of a portfolio’s returns with its benchmark’s returns, divided by the variance of its benchmark).
- In our example, we are assuming that there is only one asset class. In real life, Beta varies according to the risk level of the asset class you invest in but the principle is the same.