NEW HAVEN – In their new book The Incredible Shrinking Alpha, Larry E. Swedroe and Andrew L. Berkin describe an investment environment populated by increasingly sophisticated analysts who rely on big data, powerful computers, and scholarly research. With all this competition, “the hurdles to achieving alpha [returns above a risk-adjusted benchmark – and thus a measure of success in picking individual investments] are getting higher and higher.”
Many believe that we are almost there. Even legendary investors like Warren Buffett, it is argued, are not really outperforming the market. In a recent paper, “Buffett’s Alpha,” Andrea Frazzini and David Kabiller of AQR Capital Management and Lasse Pedersen of Copenhagen Business School, conclude that Buffett is not generating significantly positive alpha if one takes account of certain lesser-known risk factors that have weighed heavily in his portfolio. The implication is that Buffet’s genius could be replicated by a computer program that incorporates these factors.
If that were true, investors would abandon, en masse, their efforts to ferret out mispricing in the market, because there wouldn’t be any. Market participants would rationally assume that every stock price is the true expected present value of future cash flows, with the appropriate rate of discount, and that those cash flows reflect fundamentals that everyone understands the same way. Investors’ decisions would diverge only because of differences in their personal situation. For example, an automotive engineer might not buy automotive stocks – and might even short them – as a way to hedge the risk to his or her own particular type of human capital. Indeed, according to a computer crunching big data, this would be an optimal decision.
There is a long-recognized problem with such perfect markets: No one would want to expend any effort to figure out what oscillations in prices mean for the future. Thirty-five years ago, in their classic paper, “On the Impossibility of Informationally Efficient Markets,” Sanford Grossman and Joseph Stiglitz presented this problem as a paradox: Perfectly efficient markets require the effort of smart money to make them so; but if markets were perfect, smart money would give up trying.
Markets seem to be driven by stories, as I emphasize in my book Irrational Exuberance. There are stories of great new eras and of looming depressions. There are fundamental stories about technology and declining resources. And there are stories about politics and bizarre conspiracies.
No one knows if these stories are true, but they take on a life of their own. Sometimes they go viral. When one has a heart-to-heart talk with many seemingly rational people, they turn out to have crazy theories. These people influence markets, because all other investors must reckon with them; and their craziness is not going away anytime soon.
Maybe Buffett’s past investing style can be captured in a trading algorithm today. But that does not necessarily detract from his genius. Indeed, the true source of his success may consist in his understanding of when to abandon one method and devise another.
Alpha still exists! But that doesn’t mean it is easy to find, or even worth the pursuit.
Larry Swedroe, author of the bestselling series of The Only Guide investment books, and co-author Andrew Berkin bring you the quantitatively chilling tale of The Incredible Shrinking Alpha. As aficionados of classic science fiction, Swedroe and Berkin saw similarities between the monumental struggle of Scott Carey, novelist Richard Matheson’s Incredible Shrinking Man, and that of every individual investor trying to beat the market. Swedroe and Berkin explain in academic yet simple terms what is happening to the alpha for which so many investors yearn.
Offering compelling data from decades of academic research, Swedroe and Berkin present the hard truth as they know it — it’s not worth the time or effort spent battling to win those few extra cake crumbs. Instead, focus on the things you can control and discover what life has to offer beyond the quest for alpha.
From the Inside Flap
THE INCREDIBLE SHRINKING ALPHA
“Swedroe and Berkin provide a concise treatment of the research passive and active investors (both individual and institutional and also financial advisors) need to become more successful. This treatment also appeals to college finance students seeking to gain a better understanding of passive versus active investing, along with ‘the correct answers.’ The authors enable investors seeking to ‘generate real alpha’ to understand that passive investing is increasingly the correct approach, while active investing is just the opposite.”
— John Haslem, Professor Emeritus of Finance, University of Maryland, Robert H. Smith School of Business and Editor/Author of Mutual Funds: Portfolio Structures, Analysis, Management, and Stewardship
“Ever wonder why your actively managed funds almost invariably disappoint you? Piece by piece, the authors peel back the claims that active managers can add value in a system where it gets harder and harder to generate Alpha. In a world where academic research uncovers the true sources of return and markets relentlessly become more efficient, what’s an investor to do? Go passive! Swedroe is the master of explaining financial research in terms that every reader can easily understand. Read and improve your financial acumen.”
— Francis Armstrong III, Author of The Informed Investor and Investment Strategies for the 21st Century
“Based on decades of research and my personal experiences, I too gave up the quest for alpha long ago. I hold an endowed chair in investments and am a member of The Wall Street JournalExperts panel. Yet, I do not own a single individual stock or corporate bond. Rather, I invest in low-cost passive mutual funds and ETFs. Swedroe and Berkin demonstrate how this strategy can be used to achieve a prudent, globally diversified portfolio. Their book could well end up saving you a lot of money — your money — and giving you a lot of free time.”
— William Reichenstein, Investment Professor at Baylor University
“In this short but powerful book, Swedroe and Berkin have advanced the debate on active v. passive to a new level. Their discussion of how alpha (beating the market) has steadily morphed into beta (achieving market returns) is the best description I’ve read of this process yet. No polemics here, just a data centered exposition of the issues — the longtime trademark of Larry Swedroe.”
— Edward Wolfe, Professor Emeritus of Finance, Western Kentucky University
“Swedroe and Berkin roll up their sleeves and dig into decades of research to help us better understand how markets work. The result is a clear and concise synthesis of how investing can indeed be a ‘winner’s game.’ Read, study and apply their approach.”
— Tobias Moskowitz, Fama Family Professor of Finance, University of Chicago Booth School of Business and Managing Director, AQR Capital Management
From the Back Cover
“If you think you can beat the market, you need to read this wise book. Swedroe and Berkin show that whatever superior investment performance you may achieve is fully accounted for by the risks you are taking with your money and even risk compensation may be shrinking as well.