An Investment Approach to Achieve Superior Returns Consistently
alpha – excess return of an investment relative to the general market:
Contrarian – a person who opposes or rejects popular opinion:
The goal of an investment manager is to generate alpha – a return more than the general market. Investment managers are paid to achieve alpha. Investors expect a return greater than the market return when they entrust their money to an investment manager.
To achieve market returns, an investor doesn’t need an investment manager. He can invest in passive funds that track a particular index. The major benefit of passive funds is their low cost compared to active funds. There has been a significant influx of capital into passive funds over the last decade, principally due to their low cost, and additionally, due to the failure of the majority of active funds to generate alpha.
The shift to passive fund management from active fund management – is this a permanent trend that will make active fund management obsolete? Has advances in capital markets and the adoption of technology in markets made generating alpha a nearly impossible task and active management a futile exercise?
No, it has not. Generating alpha has not become an impossible task. There are strategies to generate alpha consistently that are simple and easy-to-understand. However, before going into that, it is essential to understand the concept of market efficiency and the mechanism that creates an efficient market.
Market efficiency
Market efficiency is an important finance concept introduced and popularised through the ‘efficient market hypothesis’(EMH) by Eugene Fama, a Nobel prize-winning American economist. The ‘EMH’ states that, at any time, all the available information regarding a particular company is fully incorporated into its stock price. This makes the stock price-efficient, and it is impossible to beat an efficient market. According to EMH, alpha is impossible.
But, in the real world, every now and then, we hear about a few investors who have managed to beat the market consistently over time. If market prices are efficient and alpha is impossible, as said by EMH, then how did these investors generate market-beating returns?
Three conditions need to be satisfied for the market to be efficient:
- All available information should be properly disseminated and, thus, be available to a sufficient number of investors.
- The disseminated information must be processed by a sufficient number of investors with no systematic bias.
- And, finally, a sufficient number of investors must be able to act on this information, i.e., trade on this information, so that the information is fully incorporated into the stock price.
An investor can generate alpha if he can gain an edge over other investors in any or all of the above three conditions. The investor will have an ‘informational advantage’ if he has access to company information unavailable or inaccessible to other market participants. It is very hard (almost impossible) to have an ‘informational advantage’ in the present, internet age where information is free and ubiquitous. Here, we are talking about publicly available information. Trading and profiting from unpublicized price-sensitive information is a punishable offence.
An investor can have a ‘trading advantage’ if some investors are limited by their ability to trade on the available information while some are not. That, too, is hard and difficult to attain in the present times of electronic, zero-commission trading.
The only plausible edge an investor can have over other investors that enables them to generate alpha is having an ‘analytical advantage’. An investor will have an analytical advantage if he can look at the same set of information as others but gains a different, more valuable insight than others.
So how does one gain an analytical advantage? Does learning a lot of advanced textbook finance concepts provide an edge? Do advanced investing/trading programs and certifications provide an edge?
May be. But if advanced concepts and programs provide an edge, many will gain those and try to replicate the success of those with the edge, which will eventually diminish the edge. What we need is a sustainable advantage that enables us to generate alpha consistently over long periods.
However, methods do exist that enable to generate alpha. But not in finance. Then where? In psychology. It is an approach that takes advantage of mistakes made in markets. Investors always overreact to events. This overreaction results in the overvaluation of popular stocks and the undervaluation of unpopular stocks.
We don’t know what is going to happen in the markets and economy this year or the next. However various psychological studies have shown that how investors behave in certain circumstances is systematic and predictable. Therefore, a diligent investor can gain an edge and achieve superior returns by taking advantage of these predictable investor behavioural patterns. This approach is called ‘contrarian investing’.
Contrarian Investing
Contrarian investing is an investing strategy that looks to profit by investing against the current market sentiment. If the market is bullish, the contrarian investor is bearish and will look for opportunities to sell. Conversely, if the market is bearish, the contrarian investor is bullish and will look for opportunities to buy.
Earlier, while we discussed market efficiency, the second condition required for market prices to be efficient is for the available information about a company to be processed by a sufficient number of investors without ‘systematic bias’. But biases and errors do occur and that makes the market less efficient. Biases and errors occur because market participants are humans and humans make mistakes. These mistakes are found to be systematic and predictable enabling a knowledgeable investor to take advantage of them.
David Dreman, who popularized ‘contrarian investing’ through his books, said that even though contrarian strategy is so simple, and works so well, it is not widely followed because, even though, many are aware of these winning strategies, they fail to follow through them. The most important barrier to follow through and execute these strategies is investor psychology.
According to Dreman, the success of contrarian strategy requires an investor to go against 1) gut reactions, 2) the prevailing beliefs in the market, and 3) the experts he respect.
Contrarian investing is simple and elegant, but not easy, and many fail at it because of the lack of discipline to carry it through. And there lies our sustainable edge.
An effective execution of a contrarian strategy requires an investor to overcome three fears.
1)The fear of missing out. When a stock is highly favoured by the market and the stock is having a good run, it is quite difficult to stay away from the stock when many are making big returns in short time. At such times, it is painful to stay away from the euphoria, but feels good when you join the crowd, even though you know deep inside that the stock gains are purely based on speculation. With no fundamentals backing them, the stock price rally will eventually come to a disastrous end.
2)The fear of being alone. No one wants to be alone. Most of us long for belonging and enjoy the comfort and security of being part of a group, community, or tribe. But, being contrarian, requires just the opposite. You can only develop a perspective different from the prevailing consensus by having a detached, sceptical relation with the consensus view.
3)The fear of being wrong alone. The feeling is not that bad when everyone is wrong, and you are part of that everyone. But it feels really bad and embarrassing when the collective was right while your contrarian view went wrong. So, you go along with the consensus view to avoid the embarrassment that may happen if your contrarian view turns out wrong.
Conclusion
The capital markets, today, are more efficient than they were 30 or 40 years before because of 1) advances in market participants’ domain knowledge, 2) fast and efficient ways of information dissemination and consumption, 3) fast, easy, low-cost trading, 4) and the active role played by market regulators to make the system more efficient to safeguard the interest of investors.
This has made generating alpha an arduous task, though not impossible. Contrarian investing is an investment approach that is rooted in psychology and can help in generating alpha. It is simple, easy-to-understand, but difficult to follow through. The principal obstacle to follow through the strategy is investor psychology.
An investor knowledgeable about the systematic and predictable way investors act in certain circumstances and who has the psychological discipline to overcome the fears that hinder his ability to follow through with the contrarian strategy will always have an edge in the market over others and thus generate alpha consistently.
AMN CAPITAL 