Sun 27 Aug 2006
No, not the blog (or rather the blog of other blogs).? I mean specifically the alpha that they are seeking.? What is it?? Well alpha can be what Investopedia says it is but try this?on for size:
alpha = returns of?investment? ???(volatility of?investment / volatility of benchmark) * returns of benchmark
What this is is a measure of relative performance?or advantage.? To stand higher than a benchmark, like an index for example, an investment must not only provide higher returns but do so with proportionally lower volatility.? If an investment doubles the returns of the index but also doubles the volatility (i.e. risk), then the alpha is?zero and the investment provides no real advantage.? So the conclusion is seek alpha at all times.? Sounds easy enough, right?
Finding alpha is more important than ever, but it hasn?t become any easier.? And the cost is rising.
So investing is hard work.? But alpha is what you should work hard to find.
August 28th, 2006 at 9:43 am
One way to approach “finding alpha” is to come up with realistic risk/reward ratios. Consider your investment purchase, set a stop-loss and then examine the amount of profit that you can realistically expect to make from this transaction. Is it 3 times your stop loss, 5 times, or greater? This is probably the easiest method to translate “finding alpha” into simple trading terms requiring practically no formula calculations.
Ask yourself: I’m risking $2/share on this transaction, and I stand to make $10/share if my analysis is correct. This is a better trade than one that requires a great stop-loss or has less up-side potential.
Is my explanation above overly simplistic?
August 28th, 2006 at 2:12 pm
Not at all. But I think it pretty much says the same thing. If a trade seems to require less of a stop loss than another for the same profit potential, then it has greater alpha because the lesser stop loss = lesser expected volatility.
But I think it’s important to think about alpha independently from trading tactics such as money management and stop losses too. An investment needs to have a level of “inherent” alpha to it before a trading plan is even built around it. It needs to speak to the investor and say, “I’m going to fight you less and give you more.” You’d be surprised how many people accept higher volatility in investments that return less proportionally to that volatility. Thus the rise of index investing. People figured out that this hot shot mutual fund couldn’t beat the S&P and actually had bigger drawdowns in the process. Greater risk should provide more reward but so many paths in the market take you to the flip side.
So yes risk/reward is a great way to sum it up. There is nothing wrong with more risk as long as you are rewarded reasonably for it compared to other alternatives and it fits into your overall tolerance. Seems like common sense, sure, but it’s good to keep in the forefront.