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Debunking conventional wisdom: Are you really chasing ‘beta’ or ‘alpha’?

Debunking conventional wisdom: Are you really chasing ‘beta’ or ‘alpha’? thumbnail

Conventional wisdom says you cannot make money by investing in line with the consensus. As with many successful (and damaging) fake news, there is an element of truth to it.

Unfortunately, for the vast majority of investors, this sliver of truth is pretty much irrelevant at best and extremely detrimental to wealth accumulation at worst.

Last week, I met a high net worth individual who asked me whether we were in the “overweight equities, risk of a 7-10% equity market correction and buy-the-dip” camp like most of his advisers. The answer is: Yes. But alas, the fact that the client is hearing the same from everyone else immediately switched my ‘paranoia radar’ on and nudged me to try to figure out what we are missing.

Perhaps, a more relevant question is: “Should we care about being largely in line with the consensus?” To some degree, it depends on your investment objectives. If you are looking to outperform a benchmark (i.e. generate ‘alpha’), then maybe you need to be more conscious about when there is market group-think. However, if you are merely trying to generate decent investment returns over the long term with minimal effort – that is, capture market ‘beta’ – then you need to worry a lot less.

Over any 12-month period, equities have historically, on an average, outperformed bonds 60-70% of the time. Therefore, it makes sense that the consensus is for equities to outperform in the coming 12 months – probabilistically this has been the most likely outcome.

Of course, there are reasons why this may not be the case in ‘the next 12 months’. In late March last year, the global pandemic was causing economic lockdowns on a scale we have never experienced before, raising the risk of widespread bankruptcies and a depression. Today, after about 90% gains in equities since the March lows, there are renewed fears that the Delta variant of Covid-19 could lead to renewed lockdowns, putting an end to the largely uninterrupted stocks rally.

However, this line of thinking can cause investors to make two common mistakes, which can reinforce each other to hurt investment performance. First, they invest in a narrow basket of securities or asset classes, which increases volatility of returns, making investing seem riskier than it needs to be. This, together with the common behavioural bias that the pain of a loss is greater than the emotional benefit from positive financial outcomes, results in the second mistake of keeping too much money on the sidelines (ie. in deposits, which earn little or no interest and, generally, lose purchasing power over time due to inflation).

As an investment professional, my responsibilities are two-fold: First, ensure that my team does a thorough review of the pros-and-cons of the global economic and financial outlook to try and outperform a benchmark (i.e. generate positive alpha). So, part of me worries about group-think and we have different tools and processes to quantify it.

Secondly, I am responsible for helping clients grow their investments in a safe and sustainable way that will not leave them worried, should equity markets drop a ‘normal’ 7%-10%, or even 30-40%.

In terms of relative importance, I believe my second responsibility is far more important than the first. To place this in context, we have been tracking the performance of our Asia asset allocation models for almost 10 years. While this has performed well over this period, about 90% of the total returns over this period was contributed by ‘beta’ (ie. being invested in the markets) while only about 10% was contributed by the ‘alpha’.

In my view, capturing the ‘beta’ return is far more important than worrying excessively about which asset classes to be overweight or underweight in. To help investors keep this perspective in mind and stay the course on their investments through volatile markets, there are two sources of comfort we try to provide.

First, we help investors diversify such that the downturn in their overall portfolio is much smaller in size than it would be if their allocations were highly concentrated. Secondly, we try to prepare them mentally for the inevitable market volatility and then guide them through the aftermath of any sell-off, potentially signalling opportunities that the weakness presents.

We believe, for the vast majority of investors, being fully invested and staying fully invested is the key to achieving financial freedom.

(Steve Brice is Chief Investment Officer at Standard Chartered’s Wealth Management unit. Views are his own)

(Disclaimer: The opinions expressed in this column are that of the writer. The facts and opinions expressed here do not reflect the views of www.economictimes.com.)

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