Behavioral risk is a key source of portfolio alpha

Nobel-prize winner Professor Bill Sharpe famously advised that alpha (returns that deviate from the “market” or a benchmark) sum to zero. For every investor who beats the market, the positive alpha is financed by negative alpha that accrues for another investor.

There are several implications, starting with what is perhaps the key insight: “Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs,” Sharpe wrote in “The Arithmetic of Active Management.”

The fact the alpha sums to zero lays the groundwork for behavioral risk in portfolio management, which in turn helps explain why there are winners and losers in the money game. See the related research report here.

Consider a simple 60/40 portfolio of US stocks and bonds that’s routinely rebalanced to target weights at the end of each calendar year. In this toy illustration, this portfolio represents beta – the “market”. As a practical matter, every hypothetical investor can easily and inexpensively capture this beta without forecasts, analytics or any other skill set. Rather, the only requirement is to buy and hold a 60/40 portfolio and reset the weights every Dec. 31.

For investors intent on generating positive alpha relative to the 60/40 beta, there are countless possibilities. Let’s consider one simple variation: buying and holding the equity component of the 60/40 beta portfolio that’s constructed with a pair of Vanguard index mutual fund proxies (VFINX for stocks and VBMFX and for bonds). The alpha strategy is simply holding VFINX, which tracks the S&P 500 Index. The logic here is that stocks tend to outperform bonds through time and so it’s reasonable to forecast the historical record on this front will continue.

The spread between these two strategies is shown in the chart below – when the red line is above zero, the buy-and-hold stocks portfolio is outperforming the 60/40 portfolio, and vice versa. Not surprisingly, the buy-and-hold equities portfolio outperforms the 60/40 strategy most of the time. But it’s crucial to note that there are periodic episodes when a stocks-only strategy dramatically underperforms (red line falls below zero). It is during the latter events when behavioral risk tends to spike.

Why does it spike? There’s a finite amount of positive alpha, and supply waxes and wanes for given periods, sometimes dramatically. The sudden dearth of positive alpha’s supply at times influences short-term investing decisions. The main result: some (most) investors are unable or unwilling to stand pat while their equity investments are losing money. The longer the slide, the greater the behavioral risk of selling. A portion of professionals may be more likely to resist the temptation, but managing this strain of behavioral risk is the exception rather than the rule overall.

Therein lies opportunity for a minority of investors with a longer time frame and/or a relatively robust tactical asset allocation strategy. The self-inflicted losses that prevail when many/most investors sell at or near stock market bottoms (or buy at/near market tops) provide the source for earning positive alpha by a relative few. Indeed, investors intent on earning positive alpha necessarily rely on the mismanagement of behavioral risk by the majority of investors.