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Investor Alpha ‘Readily Available’ but Not Painless: Research Affiliates

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Investor alpha, often described as elusive and hard to obtain, is actually “readily available” to any investors willing to withstand a little temporary discomfort.

So says Chris Brightman of Research Affiliates in an analysis in the Newport Beach-based firm’s current investment newsletter.

Brightman relates an evolving debate in academic finance about investor decision-making: whether it is irrational or based on valid behavioral preferences.

“Is the choice to pay a premium price for a stock that may plausibly quintuple irrational, or is it a preference for positively skewed upside, like a lottery ticket?” writes the Research Affiliates head of investment management asks.

While there are varying approaches to this question, the facts nevertheless show that most investors nevertheless underperform the market because of frequent trading, chasing past performance, increasing risk as the market rises and selling when prices collapse.

Brightman cites a study updated by Morningstar last month that shows the average mutual fund investor earned a significant 2.5% less than the funds in which they were invested on a time-weighted basis.

“Their buy and sell decisions were that bad!” he writes.

But these poor decisions by most investors are the very “source of the above-market returns earned by a few others, including Warren Buffett and Jack Bogle, who have charitably advised investors to simply (and passively) buy and hold a low-cost index fund to match market returns.

Brightman, however, argues that investors can choose to do still better through smart beta, which typically involves non-market-cap weighted indexing strategies:

“Today, above-market returns are readily available through simple, transparent, low cost, smart beta strategies,” the price of which is the discomfort investors will bear as these strategies lag the markets during times like today, when the market appears to be rewarding momentum.

On the flip side, the higher expected returns such smart-beta investors will eventually obtain is the “compensation for tolerating discomfort.”

Brightman concludes:

“The question an investor should ask is … Do I choose to fund alpha for others with my own comfort-seeking behavior, harvest alpha from others with a disciplined tolerance for discomfort, or remain passive?”

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