Alpha vs. Beta
Lance on Feb 06 2008 at 9:09 am | Filed under: Asset Allocation, Great Investors, indexes
One of my favorite people to read is Rob Arnott, who never ceases to examine every truism, shibboleth and academic orthodoxy in the field of finance. What are alpha and beta? Why and when is it important to distinguish between them.
All About Alpha reviewed some of his points a little over a year ago, and I suggest reading the whole thing, but I particularly like these two takeaways:
In his opinion, alpha/beta bifurcation is somewhat of a red herring and we should just accept returns for what they are. (North American readers may be reminded of that old Reese’s Peanut Butter Cups commercial where a person eating chocolate bumps into a person eating peanut butter and they both declare that the (fortuitous) combination “tastes great!”. But in this case, Arnott might re-write it: “First guy: Hey, you got alpha in my beta! Second guy: No, you got beta in my alpha! Together: Mmmm, performs great!”)
and
In conclusion, Arnott accuses the finance industry of being too quick to hold onto theory in the face of conflicting empirical data. In the field of physics, he explains, scientists rejoice when conflicting empirical data is uncovered since it gives them an opportunity to advance their theories and create new ones. But in finance, Arnott says we tend to question conflicting data sets and conclude that they are either flawed or simply too small.
Because experience so conflicts with academic theory, advice, especially in the media, tends to often fall in the category of “pretty good advice that isn’t really true.” Advice that keeps investors (professional and amateur) from doing things which are likely to blow up in their face and/or give in to fear and greed.
However, instead of just saying “you can’t be trusted with the truth,” an unwelcome piece of advice, they instead lean on academic theories which justify that we have no insight on the future, act as if returns and risk are always correlated positively, that past returns are pretty good guides to future returns (even as they say past performance isn’t a guide) etc.
More on examples of this type of thing in coming days.
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