Financial theory assumes that we humans act rationally and use all publicly available information to make judicious investment decisions. As such, all available information is promptly and accurately reflected in asset prices, which means delivering consistent alpha – excess return above the market benchmark returns – is an ostensibly insurmountable task. Basically according to the Efficient Market Hypothesis (EMH), outperforming the market means that you have a unique informational or forecasting advantage. And this could be true since information in today’s day and age is commoditized and has given a level playing field across managers be it large or small. However, irrational exuberance and pessimism, particularly during volatile market conditions along with herd mentality, market’s euphoria etc. contradict these fundamental assumptions.
Of course uncertainty or risk in the market is important to understand when talking about Alpha. If you are investing, you need to be comfortable with the constant presence of uncertainty – uncertainty of risk, of unpredictable events etc. And relying on forecasts when looking to generate Alpha can be tricky. John Kenneth Galbraith, a famous economist, summarises the point succinctly:
“There are two types of forecasters – those that don’t know and those that don’t know they don’t know. The [latter] are the dangerous ones, the people who think they know what the future will behold.”
Finding Alpha Consistently:
For those that want to find alpha consistently from the market, here are a few things to consider:
A. Strategic Forecasting
- Adopt a Probabilistic Approach: Moving away from binary or deterministic forecasting towards a probabilistic approach that accommodates a spectrum of potential outcomes.
- Sensitivity Analysis: Engaging in sensitivity analysis to discern how susceptible investment thesis is to variations in underlying assumptions.
B. Focus on the Basics
- As an individual investor, prioritize a small subset of critical factors (quality, value, momentum) as primary determinants in the investment analysis.
- Employ automated tools to consistently evaluate basic factors so as to remove any bias from the process and to focus only on the data-driven, systematic analysis of the investment opportunities
- P.S. at Wright Research, we analyze over 300 factors to build our investment portfolios
C. Mitigating Behavioural Biases
- Make sure to look at contrarian views rigorously to ensure your behavioural and cognitive biases are in check
- As an individual investor, you can maintain a decision journal that archives investment decisions, rationales, and expected outcomes to help you learn from your successes and your failures.
D. Portfolio Review & Rebalancing
- Conduct regular portfolio reviews and systematic rebalancing to ensure the portfolio doesn’t stray too far from its strategic allocation due to the differential performances of underlying investments
- During the portfolio review, also analyse if the alpha generation potential is disappearing and find ways to continuously improve and optimise the portfolio to give you the alpha that you want
- At Wright Research, we continuously monitor and review our portfolios to ensure alpha decay is at a minimum by rigorously testing thousands of market scenarios and events. This enables us to provide sharp, laser-focused portfolios that have the potential to generate alpha returns
At Wright Research we have several alpha strategies such as Alpha Prime and Momentum where we are consistently beating the benchmark and generating alpha for our users. Our focus is on the investing process, analytical research, quality, efficacy of the quant models used and proprietary AI models & deep machine learning to give us an edge in this world of abundant commoditized information. We use all of this to make sense of what has happened in the market historically, the many thousands of ways that the market could move tomorrow, day after, 1 week later, 1 month later etc. We deploy probability and statistical models along with our proprietary AI models to understand the likelihood of specific market events occurring and how to identify pockets to generate alpha.
Explore Alpha Prime smallcase here
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