Summary of the book "Better than Alpha" - By Christopher Schelling

Key Concepts in this book:

1. Alpha is alluring, but it's also untrustworthy and susceptible to manipulation.
2. Because of the increase in market elements and data, true alpha is dwindling.
3. Cognitive biases can lead us astray, so don't put your faith in your gut instinct.
4. Slow, methodical thinking should be saved for the most important, long-term decisions.
5. To increase your investment performance, use the 5P framework during the due diligence process.
6. Choose a charismatic and experienced leader for investment success.
7. Instead of chasing alpha, employ tried-and-true tactics to improve your odds.

Who can benefit the most from this book:

• Investors who want to make better decisions and improve their portfolios.
• People with an interest in behavioral finance.
• Anyone who wants to see through the hype and learn the truth about alpha.

What am I getting out of it? An investment strategy that is well-thought-out.

Investors are preoccupied with discovering alpha; they want to maximize their investment returns and outperform the market.

However, alpha is not always what it appears to be; a closer examination of investments frequently reveals that the so-called alpha is actually something else entirely.

The author has discovered an alternate strategy after years of expertise in the field of institutional investing. There's a better way to fulfil your investment goals, and it starts with redefining your definition of success.

Alpha isn't the be-all and end-all — there's a better option.

• You'll learn why the pursuit for alpha is often doomed to fail.
• Why you shouldn't always trust your instincts.
• And one of Warren Buffet's success secrets in this summary.

1. Alpha is alluring, but it's also untrustworthy and susceptible to manipulation.

Alpha. If there's one thing you and your fellow investors have in common, it's most likely a fascination with this enticing yet elusive prize. Alpha, like a gorgeous mirage, appears to vanish when examined more closely.

Let's define alpha, a term that's frequently misunderstood, before delving deeper into this riddle. The extra return of an investment over the benchmark index is known as alpha. To put it another way, alpha is a measure of how effectively an investor outperforms the market. Beta, on the other hand, is the index return obtained from the passive ownership of assets in a certain market.

You want alpha, not beta, as an investor. That is, however, easier said than done.

The main point is that while Alpha is appealing, it is also unreliable and readily manipulated.

Managers can readily manipulate alpha to their own benefit. They can display excess returns as alpha by creating their own index and selecting an easy-to-beat beta. However, not everything that glitters is gold, as the saying goes. When examined closely, this so-called alpha is frequently revealed to be beta. This is why it's critical for executives to adopt effective benchmarks before investing.

Alpha is annoyingly unpredictable and random. It appears and vanishes. In public markets, private equity, and hedge funds, this trend is evident. The latter appeared to be an alpha success story at first, with hedge fund legends like Warren Buffett and Barton Biggs raking in huge profits.

However, research reveals that hedge fund alpha has been declining since 2005. The author uses the example of a hedge fund that boasted "100 per cent pure alpha" historical results only to collapse a few years later.

Alpha's unstable nature provides a particular difficulty for major asset owners, who may be forced to reassess billions or trillions of dollars in capital allocations. It's a little like navigating a gigantic plane when you're working with such a large amount of money. It takes some time to get up to speed, and you can't change direction quickly.

Individual investors must likewise exercise caution. As individuals have access to alternative assets such as private equity and hedge funds, more people are in danger of being duped by the alpha mirage.

It's all too tempting to believe the hype or become perplexed by acronyms and phrases. We'll take a closer look at the true nature of alpha – sans the jargon – in the following concept.

2. Because of the increase in market elements and data, true alpha is dwindling.

We frequently make the mistake of viewing alpha in simplified terms, when it is considerably more complex. Alpha isn't a fixed value; it exists on a scale.

There's true alpha, for starters. This is the process of generating excess returns just by selecting securities that are not in line with the market. Without any tilts like sector bets or dividends, this kind of alpha is actually beating the market.

Manufactured alpha, on the other hand, is the process of generating value through a series of modifications. For example, if management purchases a run-down flat with the intention of renovating it and increasing its worth, this is a form of manufactured alpha.

Transitional alpha is a fleeting and unpredictably unexpected state. Holding an asset for a length of time until prices stabilize can provide this type of alpha.

The majority of investors are looking for actual alpha, which is idiosyncratic and becoming increasingly difficult to come by.

Here's the main point: Because of the increase in market elements and data, true alpha is dwindling.

It's like looking for a needle in a haystack when hunting for real alpha. Unfortunately, the needle is getting smaller as the haystack grows larger. True alpha, which is fast fading and turning into beta, is showing an accelerated fall in studies.

The substantial growth in variables — the things that determine returns, such as market capitalization or volatility – is one explanation. Because Alpha is a residual, it has unavoidably fallen in value. There is less left over for alpha if there are more components.

The data explosion is another aspect of the problem. The Library of Congress has more than 32 million books, which it has amassed over the course of 200 years. The globe now generates enough fresh data to fill 250 libraries of Congress in a single day. Every single day, to be exact.

We just cannot keep up with the amount of data available.

Clearly, the methods that were effective in the past are no longer effective. We'll have to do things differently to uncover alpha and enhance portfolio outcomes. And we can't only rely on technology; complex investment decisions still demand human knowledge and creativity.

One strategy is to hunt for alpha in various locations; opportunities exist in areas where capital and information are in scarce supply. Another technique is to make alpha, which is more convenient than discovering genuine alpha. However, it may be argued that our priorities are in the wrong place. Aside from alpha, we'll have to change the way we think if we want to make effective financial judgments.

3. Cognitive biases can lead us astray, so don't put your faith in your gut instinct.

Consider the following experiment, which might be carried out by a primitive human. A man throws a few rocks and several logs into a river. The rocks constantly sink, while the logs always float, he notices. He comes to the conclusion that rocks are naturally heavier than logs.

But he's mistaken. This type of reasoning is an example of the inherence heuristic, a cognitive bias. We have a tendency to notice a pattern and then transform it into a story to explain it. We do it all the time because it's easier than thinking analytically.

Here's the main point: Cognitive biases can lead us astray, so don't put your faith in your gut instinct.

The inherence heuristic also deceives investors. One example is the illiquidity premium or the additional return an investor could obtain on bonds that aren't actively traded. Certain publicly traded assets have historically outperformed. However, we can't assume that outperformance is a constant or fundamental characteristic of these assets. Dividend yield – how much a firm pays to its shareholders each year in relation to its stock price – is one element that affects returns.

So don't make the mistake of assuming that some assets will always perform well. You're making the same mistake as the primitive man if you think like that!

We are continually influenced by cognitive biases, even if we aren't aware of them. For example, we're influenced by confirmation bias, which is a propensity for information that supports our previous opinions. Alternatively, in our haste to avoid loss, we fall prey to the sunk cost fallacy and cling to when we should let go.

These biases are unavoidable to some extent - we're hardwired to think in this way. Our primitive brains, on the other hand, fail to make quick, correct assessments when it comes to complex financial decisions.

So, with that in mind, should you put your faith in your gut? Most likely not. No one, no matter how convinced they are, has a supernatural capacity to beat the market.

Returning to the rock experiment, we can discover what is truly important: knowledge. We now know that the density of atoms in an object impacts whether or not it floats, thanks to study. It has nothing to do with a rock's fundamental properties. Similarly, there's undoubtedly another reason for certain assets' apparent performance; we only need to dig a little deeper.

Continue to learn to overcome your inherent limitations. Warren Buffett spends up to eight hours per day reading. Yes, it's a lofty goal, but if you're serious about success, you have to shoot for the stars!

4. Slow, methodical thinking should be saved for the most important, long-term decisions.

As a result, our gut instincts are frequently incorrect. So, we should probably avoid making snap decisions and instead consider things thoroughly - right? Actually, it is debatable. In certain contexts, different types of thinking are beneficial.

Let's have a look at the model proposed by Daniel Kahneman in his book Thinking, Fast and Slow. System 1 is characterized by quick, intuitive thinking, and System 2 is characterized by slower, analytical thinking. System 2 thinking produces more accurate results in general, but it is also taxing. Our brain resources are limited.

According to a 2011 study of Israeli parole hearings, offenders who had their hearings in the morning had a 65 per cent chance of getting parole. That possibility was nearly zero for offenders who had their hearings at the end of the day. Judges were exhausted, so they began to depend on System 1 reasoning, automatically rejecting parole requests.

It merely goes to prove that no one has the energy to think in System 2 all day.

Here's the main point: Slow, methodical thinking should be saved for the most important, long-term decisions.

Every day, the average worker makes up to 40,000 decisions. Rather than wasting time and energy on a plethora of small, meaningless decisions, we should strive to make fewer, larger judgments – and make sure they are correct. That means relying on System 1 the majority of the time; we need to save mental energy by only using System 2 for critical decisions.

What are the most crucial stages of the investment decision-making process? According to the author, we should save our System 2 thinking for the early stages of asset allocation and policy development.

Let's start with the first stage, policy formulation. Decisions should be made in an informal setting, allowing everyone with relevant information to participate. You'll be more likely to get the best ideas this way.

A detailed discussion of goals and a clear definition of how success should be judged should be the first step in policy development. In addition, the organization must define risk and establish a deadline. Then give yourself plenty of time to conduct thorough research and thoughtful deliberation on the policy and investment goals.

After that, and only then, should you make your final selection. Produce a complete investment policy statement once everything has been documented; this will help you make future decisions. You'll be well on your way to investment success if you use a similar cautious and meticulous approach to asset allocation.

5. To increase your investment performance, use the 5P framework during the due diligence process.

We've talked about how to use System 2 thinking to address the early stages of the investing process. We must, however, rely on rapid, unreliable System 1 thinking the majority of the time. How can we make excellent decisions in these situations more efficiently?

Consider the due diligence step of the investing process, which entails thorough research of a potential investment, including risk assessment and prior performance appraisal. Due diligence is less strategic than policy formulation. Although System 2 thinking isn't required, a framework can assist you in achieving your goals.

Here's the main point: To increase your investment performance, use the 5P framework during the due diligence process.

Performance, people, philosophy, process, and portfolio are the five major aspects that make up this framework, and they all start with the letter P.

Manager selection affects two of these factors: performance and people. Analyze a manager's historical performance before hiring them so you can set realistic expectations for results. Look for a manager who exemplifies intelligence, ethics, and intensity. To put it another way, you want an expert who is enthusiastic about their profession and whom you can entirely trust.

You should also think about the investment team's work attitude; responsibility and empowerment should be their unifying goal. The team must work together, share common values, and have complementary abilities.

It's also crucial to follow the proper procedure. A consistent, predetermined approach must be followed by the manager for the best results. Analyze the portfolio in detail as part of this procedure. Continue to keep an eye on the portfolio and manage it, ideally through tactical asset allocation and rebalancing.

It's critical to do your due diligence correctly; research suggests that it can have a big impact on performance. One study looked at angel investments on the startup site Fundify, for example. Early-stage investments can be risky, but the study found that the ventures that succeeded best were those in which investors put in at least 40 hours of due diligence.

Due diligence can lead to alpha or it can't. However, keep in mind that your ultimate goal should be to increase your profits. You're much more likely to succeed if you take your time and follow the 5P structure.

So far, we've focused on how to make better decisions and processes. Following that, we'll look at the third component of the puzzle: governance.

6. Choose a charismatic and experienced leader for investment success.

The consequences of putting the incorrect person in control can be severe. The Dallas Fire and Police Pension, for example, found itself in a grave financial situation as a result of ill-advised real-estate purchases. These investments were overseen by a chief administrator who lacked essential competence. His professional expertise included owning and operating a fast-food business, and his idea of due diligence consisted of lavish vacations in locations with possible investment opportunities.

Poor governance may not always result in financial ruin, but it is almost always detrimental to investment success. Choosing the wrong manager is one of the key determinants of bad investment outcomes, according to many research studies on investment governance systems.

Here's the main point: Choose a charismatic and experienced leader for investment success.

It's obvious that finding a capable leader should be a top concern. On the other hand, a person who appears qualified on paper may not be the ideal fit for your company. Some professionals, for instance, might make competent leaders. They'll struggle to motivate their squad if they don't have natural charisma.

Consider Donald Trump as an example of a leader. Whatever your political opinions, Trump's charisma and ability to influence and drive people are undeniable. Leaders in the investment industry must also be charismatic.

Another important leadership characteristic is experience. In most cases, an experienced expert is better at assessing risks and making judgments. A study published in the Journal of Psychiatric and Mental Health Nursing in 2001 revealed the link between experience and decision-making. Nurses, like investors, are frequently required to make future predictions based on a range of inputs – and often without perfect knowledge. Nurses with more experience can make more accurate diagnoses. A professional who has seen 2,000 hedge funds, on the other hand, is more likely to make better selections than a manager who has just seen a few.

To summarize, the ideal leader is strong, motivating, and knowledgeable - a seasoned professional. Remember, in order to get results, this leader must be in the right location at the right time. Charismatic experts are placed in positions of hierarchical power in the most effective organizations. If you can't get experts into higher-ranking roles, delegate actual authority to the most qualified people, regardless of their title.

You can minimize inefficiencies and make it much easier to reach your investment goals by putting the proper people in control. And, unlike alpha, you have influence over the management you choose.

7. Instead of chasing alpha, employ tried-and-true tactics to improve your odds.

The investor with the Midas touch is just that - a legend. Despite the hoopla, alpha remains largely out of reach. Is this a sign that it's time to give up on alpha for good?

In a nutshell, the answer is yes. Alpha is elusive and intriguing, as we've seen. When you look at the data for public markets, it's evident that most excess returns were never intended to be alpha in the first place. In retrospect, it was most likely the consequence of a combination of variables — or plain luck. As a result, if you work in public markets, you'd be better off ignoring alpha. Instead, focus your efforts on obtaining the most affordable indexes and factor exposures.

It's a similar trend in private markets, where finding alpha is becoming increasingly difficult. If you want to make a lot of money, you'll need to be creative and know where to look. Work with smaller, more nimble managers to improve your chances of success. Look for someone who can truly teach you anything new, according to veteran investor Larry Siegel.

Here's the main point: Instead of chasing alpha, employ tried-and-true tactics to improve your odds.

If the returns are good, what's the point of caring about alpha and exceeding a benchmark? What matters most, in the end, is the entire net return. True success is achieved when you achieve your goals, even if it necessitates some volatility or illiquidity.

The Investment Board of the State of Wisconsin is a good example. Smart governance strategies and long-term, rule-based processes are used by this company. The investments are also overseen by a highly educated professional. They regularly beat their policy benchmark year after year.

The Board increased its chances of success and achieved great results by using sound investment methods and decision-making. It even got to alpha!

This prudent technique can benefit every investor. Adopt a more rational, scientific attitude to investing in the future — and retain an open mind. Of course, there will always be an element of chance, and you will almost certainly make some little errors along the way. However, the idea is to approach everything as a learning opportunity.

So, forget about alpha and the Midas touch when making your next investment. It is up to you and your company to produce the gold.

The essential takeaway from these blinks is that in their quest for alpha, investors frequently end up on a wild goose chase. Finding alpha has always been hit-or-miss, and it's even tougher these days – so don't waste your time and effort! Instead, concentrate on developing your decision-making skills, adhering to a sound framework, and building effective governance. You'll have a lot better chance of generating good returns – and that's so much better than alpha at the end of the day.

Advice that can be implemented:

If something works well, make it a system.

Automate various steps of the investment process to make it more efficient and accurate. Make checklists to find the best managers, for example. Consider it a safeguard against future blunders – those inevitabilities that come with System 1 thinking!