Alpha & Beta: Two Competing Investment Philosophies

“Where’s the Dow going to be in a year?”

That’s often asked of financial TV guests. From their responses, you’ll detect two distinct investment philosophies emerge. Which answer resonates with you most strongly probably determines the sort of investor you are. It also affects the odds of how well your portfolio is likely to do.

Imagine it is a random Wednesday, and despite my past warnings about noise, you have a television tuned to a financial news station. That very question is posed to two television guests; let’s call them “Alpha” and “Beta.” Their answers — which are quite different — reflect their competing investment schools of thought.

Guest Alpha’s response is very specific. Yet it incorporates so many factors, it’s hard to keep up with. Rather than fill this in with the news of the moment — Fed raising rates! China devaluation! Greek bailouts! Gold collapse! — I have left the details blank so this remains “evergreen.” This not only shows how many variables are involved, but it avoids the emotional response you may have to any of these specific issues.

So Alpha is asked where the Dow will be in a year, and he responds:

“Our view is that the economy in the U.S. continues to _______, and we foresee _______ problems overseas ______. China is _______, and that has ramifications for the Pacific Rim’s ______. Greece is ______ in Europe. The commodity complex is causing _____ for emerging markets. But many sectors of the U.S. economy remain _______, and some sectors overseas are still _______. The valuation issue continues to be _____, and that means _____ for investors. That has ramifications for corporate profits that will be ______. We think the economy is going to do ______, and you know that means inflation will be _____, which will force interest rates to ______. Under these conditions, the sectors most likely to benefit from this are ______, ______ and ______. The companies best positioned to take advantage of this are ____, ____ and ____. Based on all that, we especially recommend an overweight allocation to ____, ____ and ____. Thus, we believe the Dow will be at ______ next year.”

You can turn on FinTV any day of the week and hear some variation of that discussion.

Want to know what this means to an investor? We can dissect it together:

Let’s begin by noting how many macro things that Alpha has to get right for his market forecast to be accurate. First, he is making a valuation call on several markets. That is often a challenge to do. Next, he is dissecting multiple economies around the world, including the additional burden of anticipating a variety of geopolitical events. This is complicated by the rate of inflation and the direction and levels of interest rates. Once those economic issues are determined, he must then apply that to various market sectors. From there, he must figure out which companies are best positioned to benefit from the overall analysis. All the while, he must get the timing just right — not too early or too late.

Alpha is looking to deploy capital by determining valuation/economic/geopolitics/sector selection/stock picking/market timing analysis. Easy as pie! What I love about this answer is how easily it will be derailed by just about anything. Short of perfection in all of those unpredictable variables, it is destined to fail.

Thus, for Alpha to express his views in a meaningful investment posture requires a degree of accuracy and precision that nearly all investors lack. Of course, we know the names of the greats who manage to accomplish this. But like white tigers, albino whales and unicorns, their rarity is what makes them so notable.

Guest Beta breathes a deep sigh, and says: “The future is inherently unknowable. A year is a long time in the economy and the markets. We don’t know what is going to happen in so many things. Start with jobs, and especially wages. We have no idea if the present trend continues, accelerates or reverses. But each of those outcomes will affect retail sales, but also home purchases and durable goods like autos. We don’t know where inflation will be over the next 12 months, and how the Fed is going to respond to that. We have no idea what earnings are going to be (but we do know estimates tend to run higher most of the time than actual earnings). So we do not know how expensive stocks will be over the four quarters. In most years, markets are in between plus or minus 10 percent, but even that range does not cover all the possible outcomes.”

The anchor is often perplexed, or at least a little confused by now; some become annoyed when a guest refuses to play the forecast game. Occasionally, a very good interviewer will ask a question such as, “So given the future is unknowable, what should investors do?”

A reasonable answer is as follows:

“We don’t know what the future holds, but we can make some reasonable assertions based on long-term historical data. We know that holding non-correlated asset classes provides diversification benefits, one of the few free lunches on Wall Street. Large-cap and small-cap stocks in the United States, equities of emerging markets and developed nations, Real Estate Investment Trusts, Corporate Bonds, Treasury Inflation Protection Bonds, High Yield Bonds and, of course, old-fashioned Treasuries.

“We hold these in a proportion that matches your risk tolerances — more equities for those with a reasonable appetite for growth, less for those who are less comfortable with volatility. Assuming no major life event changes and your risk tolerance (notice the direction of the market should not determine your true risk tolerance), rebalance once or so a year in order to not stray too far from your original allocation.”

The first answer gives the anchor a lot to discuss. Any one of those blanks represents a follow-up question. An hour can slip by before Alpha starts to run out of things to chat about. If you are in the content creation business, Alpha gives a terrific interview.

The conversation with Beta is much shorter. It is more accurate. It better reflects how most investors should be handling the bulk of their assets, but it’s too short and too boring to make for good television.

In any given year, a substantial portion of people who subscribe to the Alpha school will do exceedingly well. It is rare for them to do this two years in a row, rarer still to do it for any substantial length of time. Once costs, taxes, fees, etc. are taken into account, the Alpha school of thought consists of a handful of brilliant outliers and 90 percent or more of wannabes and total misses. Best of luck with that.

The philosophies of Alpha and Beta are often referred to as Active or Passive, but that does not do justice to the differences.

Do not get me wrong; I have nothing against people putting money with Alpha, so long as they (a) understand the very long odds against achieving success, and (b) keep a substantial percentage of their assets with Beta.

To be fair to Alpha, we must also recognize that while Beta does well over the long term, over the short term she careens between boring gains and frustrating drawdowns. Nor does Beta give you much to talk about at cocktail parties. Beta is boring. That’s the way investing should be.

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Ritholtz is chief executive of Ritholtz Wealth Management. He is the author of “Bailout Nation” and runs a finance blog, The Big Picture. On Twitter:@Ritholtz.