How to Invest
I’ve worked as a Wall Street banker, a foreign exchange trader and a fixed income portfolio manager since 1978. I’d like to share some of the secrets I’ve learned about how to make money and how to invest it. I’ll discuss buying stocks and penny stocks, stock brokers, day trading, margin trading, mutual funds and exchange traded funds, retirement planning, 401 K rollovers, Roth IRAs, college savings plans, REITs, options trading, commodities and commodity futures, foreign exchange trading, future trading, gold investing, fixed income investing using bonds, Treasury bonds, zero coupon bonds and municipal bond and finally venture capital investing.
Beta and Alpha
Before writing about buying stocks and bonds, I need to teach some vocabulary. There are many different things you can invest in like stocks, bonds, commodities, gold, etc. Professionals call these categories of investments “Asset Classes.” Each asset class can be thought of as a market where the average value goes up and down. This rise and fall in the price of the market is called its “Beta.” Active money managers make decisions to vary their holdings of securities or instruments in an asset class. The returns from these decisions are called “Alpha.” Stated another way, the return the market gives you is your Beta and the return a manager gives you above or below the market return is your Alpha.
The most important decision you will make as an investor is what mix of asset classes you will use. This is called “Asset Allocation.” More than 90% of the risk in an investment portfolio is determined by the percentage of each asset class you decide to hold in your portfolio. This will determine the mix of Betas you are exposed to. The second most important decision you will make is the managers you choose to invest in those asset classes. This will determine how much Alpha you can harvest or whether your returns will beat the market or be below the market. I’ll give you some hints on how to determine the best asset allocation for you and how to choose the best managers (which for some people might be themselves.)
The return on your overall portfolio will be the simple weighted average of the return streams you choose from the Betas and the Alphas or from the asset allocation decision and the choice of managers. It is important to understand that the return stream from Betas and from Alphas have very different characteristics. Ray Dalio from Bridgewater Associates writes in a memo titled “Engineering Targeted Returns and Risk dated January 10, 2003,
“Betas (i.e., asset classes’ returns) are limited in number (i.e., there are not many viable asset classes), they are normally relatively correlated with each other and their excess returns (i.e., returns above cash) are relatively low relative to their excess risks (i.e., their Sharpe ratios are typically between 0.2 to 0.3). But they are reliable – i.e., we can be confidant that it will be profitable to hold them instead of cash, over long time horizons.
Alphas (managers’ value-added), on the other hand, are plentiful, they are relatively uncorrelated with each other and their returns are unreliable – i.e., their risk-adjusted returns are slightly negative on average and the range around this slightly negative average is very large over long time horizons. The risk-adjusted returns of alpha are slightly negative because a) value-added is zero-sum – i.e., in order for one manager to add value, another one must lose – and b) there are transactions costs. The range of risk-adjusted returns around this slight negative average is enormous because, in this zero-sum game, the smart managers will take money away from the dumb ones. These characteristics of alpha make the rewards and penalties of a) choosing managers and b) balancing their alphas well or poorly, very large. Unlike the returns that come from beta (i.e., holding asset classes), which you can be confident will be positive over time regardless of which you chose; the returns from alpha might not exist if you do not choose wisely. But, if you select well, you can create a much better portfolio of alphas than you can of betas because you have many more, less correlated and more attractive return streams to combine in an efficient portfolio.
So:
a) While the ability to create an efficient portfolio of betas is limited
by the limited number of them and their relatively high correlation, the
confidence
that you will eventually have a positive result, even if you choose poorly,
is high; and
b) While the ability to create an efficient portfolio of alphas is great
because of the large number of them and their relatively low correlations,
the penalties
for choosing poorly are large.”
Let me define a few more terms that Ray Dalio used. Ray used the term correlation several times. Modern Portfolio theory tells us that we want the asset classes we use to be as uncorrelated as possible. That way, when some of our investments are going down, others will be going up, minimizing our possible losses. Harry Markowitz, in a 1952 paper described how to find an optimal portfolio for any given level of risk. The key to a Markowitz efficient portfolio is to find the mix of assets with the lowest correlation amongst the various asset classes used. This sound complicated, but it can be accomplished with less trouble than you might think.
Ray also mentioned Sharpe ratios. A Sharpe ratio measures the excess return available per unit of risk. The higher the Sharpe ratio, the better the investment.
Now we have some basic vocabulary, we can look at the asset allocation decision and decide what percentage of stocks, bonds, commodities, gold, REITs and foreign exchange we want to buy.
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