I came across this old Morningstar interview featuring Pat Dorsey of Sanibel Captiva Trust. He discussed the three sources of alpha, as outlined by Russell Fuller in Behavioral Finance and the Sources of Alpha [pdf].
The first two sources of alpha:
- Superior (Private) Information: Most traditional investment managers try to generate a better information set. For example, they may try to generate a superior earnings forecast, or they may try to better understand the economics underlying a particular industry’s profitability. These types of managers are frequently referred to as traditional managers or fundamental managers.
- Process Information Better: Some investment managers assume that most information is commonly available to all investors and focus their energy on trying to develop better procedures for processing this information. Managers that try to do this in a formal way are frequently called quantitative managers.
Fuller suggested that these two sources raise the important question: How likely is it that an individual investor investment manager will be able to consistently gather superior, private information, or process that information better, when so many others are attempting the same thing?
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Dorsey says that in small caps, even individual investors can have a consistent advantage by diligently tracking those firms too small to warrant any attention from institutional buyers.
Even as a small investor, if you’re diligent and you work hard on a smaller business, they are not very well followed by Wall Street; they are not very well owned by money managers. So, you can get to know them a little bit better than everybody else, but for the kinds of stocks that Raj Rajaratnam was trading, the informational advantages only come in less than legal ways.
But critically, I would say that generally informational advantages don’t exist outside of very small companies.
This leads to the third source of alpha:
- Behavioral Biases: Scholars in psychology and the decision making sciences have documented that in some circumstances investors do not try to maximize wealth and in other circumstances investors make systematic mental mistakes. Both of these cases can result in mispriced securities and both are the result of behavioral biases.
Here’s what Dorsey had to say about this:
But the reality is that, simply acting a little bit more rationally than everybody else, having that behavioral advantage, I think is a far more achievable source of alpha than actually out-thinking everybody else, because there’s a lot of money, a lot of computing power, even a lot of shady tipsters being thrown at trying to get more information than the other guy. But if you just kind of sit back and say, can I just behave a little bit more rationally? I would say that’s pretty achievable given how irrational the market can be.
Thus, the intelligent investor’s objective should be to develop a great understanding of behavioural biases, both in order to avoid making these mistakes with your own investments, as well as to identify opportunities created by others’ biases.