Alpha is finance-geek speak for an investor’s skill that allows her to outperform an index, like the S&P 500, on a risk adjusted basis. At a recent behavioral finance conference, I sat on a panel that addressed the idea of behavioral alpha. Our moderator asked, “What is it and how do we get more of it?”
I offered the observation that, in a sense, all alpha is behavioral. Whether you follow an algorithm (set of automatic rules) to select investments, decision rules, gut feeling or all three. It is a human who is making the trading decisions. (Even an algorithm is programmed by humans, with all their biases and skills.)
We know that most individual investors create negative alpha. Their returns lag indexes. Indeed, a notorious study by Fidelity found that the best performing individual accounts were those that the owner forgot about. Indeed, the average retail investor lags major indexes by several percentage points.
Investor returns in stocks and bonds have lagged indexes.
At the behavioral finance panel, I argued that the now-classic behavioral economic concepts of cognitive biases and noise can help us understand why negative alpha happens and how to reduce it. We discussed how individual investors and professional traders alike have been known to hurt their results by:
- Over-trading: we can be overconfident, too frequently adding and subtracting from investments, relying on an inflated sense of our ability to separate signal (information) from noise. We are programmed to see patterns (even where none exist), based on the availability in our memories of superficially similar situations, which may not be relevant. Over-trading hurts returns by causing us to miss opportunities while increasing trading costs. Indeed, these costs often exceed the value of any skill even a professional manager may have.
- Waiting too long to buy: we may also miss an ideal entry point and buy too late as a consequence of the Fear of Missing Out(FOMO).
- Waiting too long to sell: we focus (“anchor”) on the purchase price of an investment and delay selling too long because our loss-aversion is just too intense (on the other hand, we sell our winners too soon). Of course, the purchase price is a sunk cost that ought to be ignored: trading decisions are generally about future performance.
Noise refers to irrelevant environmental factors that affect our decisions, making them inconsistent and less accurate. Consider the famous study of the Israeli parole board that freed exactly zero prisoners, just before lunchtime, when the board was probably cranky. Also, we know that the market tends to be up on sunny days.
On the other hand, there’s research that suggests that the right kind of practice, deliberate practice, can improve our performance in many realms of decision-making. Deliberate practice describes a thoughtful and systematic process of acquiring a skill, usually with the help of a coach, who can give you objective, immediate and constructive feedback over a period of many, probably thousands of hours. It’s also important that the context of the decision is regular and predictable so that the learning is actually helpful. While the investment environment may have some regularities, these may be hard to find.
Beginning professional traders may be able to find a coach, and are supported by loads of information and analysis to help them. Individuals: not so much.
The most direct thing individuals can do to reduce their negative alpha, is to trade as little as possible, minimize costs and above all, keep it simple.
Everyone I have coached with their personal finances has not invested at all, as a result of inattention, procrastination, loss aversion and lack of financial education. For example, one client put her son’s college fund in a savings account for the past ten years, forgoing the chance to more than double her savings in a diversified portfolio. She just did not know how to get started and hadn’t made the time to learn. This lost opportunity is arguably a much more important source of negative alpha for most people.
In my experience, the first step is some basic financial education. This should include, at minimum, effective budgeting, investing alternatives and debt management. For people with high-cost debt, which means most Americans, paying this down should be a top priority, even before investing.
There are many apps that purport to help you save. Indeed, I built one of them. But I’ve learned that many, perhaps most people, need a human coach to get them started. Only then could an app be helpful to maintain good habits such as saving regularly and investing deliberately and at low-cost, while giving one’s biases and noise as little scope as possible to hurt our returns.
In sum, behavioral alpha is about building our skills and knowledge about both the financial markets and our own decision-making processes. The first job is to avoid the costly mistakes. Even if we can get lots of deliberate practice, data, analysis and support, it’s clearly very difficult to trade in a way to beat indexes, after fees and expenses. Certainly, addressing cognitive biases and noise is part of that process. We need to acquire basic financial literacy and keep our investing simple, boring and cheap enough to avoid the worst mistakes. For all of us, getting our behavioral alpha from very negative to close to zero, would be an enormous benefit.
This article originally appeared on April 20, 2019 at Forbes.com.