Alpha has, over the last fifty years, become the standard way to measure the active return of a portfolio: how much the portfolio outperformed the benchmark. Technically, however, it’s a point on a line, specifically the point where the line crosses the y axis.
The other night I asked my son, a high school student who knows next to nothing about economics or the stock market, “Which is more likely to grow faster, a small company or a large company?” He answered, “A small company.” Then I asked him, “Which will rise in price faster, a company whose price is cheap compared to what it earns, or a company whose price is expensive?” He answered, “The cheap one.”
Mauboussin writes, “Great investors do two things that most of us do not. They seek information or views that are different than their own and they update their beliefs when the evidence suggests they should. Neither task is easy. . . . The best investors among us recognize that the world changes constantly and that all of the views that we hold are tenuous. They actively seek varied points of view and update their beliefs as new information dictates. The consequence of updated views can be action: changing a portfolio stance or weightings within a portfolio.”
Whenever you come up with a new investment idea—whether it’s a new security to buy, a new factor to consider, or a new strategy to implement—you naturally ask yourself whether this new idea will increase your portfolio returns or cause you to lose money (and, of course, how much). Thinking probabilistically involves assessing the probabilities and coming up with a reasoned answer.
Investors compare all day: stocks versus bonds, active versus passive, value versus growth, stock A versus stock B, and now versus later. Humans are quick to compare but not very good at it. Perhaps the most important comparison an investor must make, and one that distinguishes average from great investors, is between fundamentals and expectations.