The price of risk

Dear Gala,

Sooner or later someone is going to sit across a table from you, in a nice office, and tell you they can beat the market. They will be well dressed and well prepared and they may even believe it. I want you to understand, before that day comes, what they are actually claiming, why it is so rarely true, and how to tell the difference. It comes down to two Greek letters, and I promise they are the only two you will need.

Beta

Imagine you put a boat on a river. The river is the market. Most days it flows downstream, some days it runs backward, and over long stretches it carries everything on it a long way. If you do nothing at all, your boat moves with the current. That movement, the part of your result that comes simply from being on the river, is beta.

Here is the thing about beta: it is almost free. You can buy the whole river for a few hundredths of a percent a year, through an index fund, and collect whatever the current gives. Over the last century in America the current has been generous, seven or eight percent a year after inflation, with terrible years mixed in. You did nothing clever to earn it. You just stayed in the boat.

A man named William Sharpe worked out the theory of this in 1964, when he was thirty. He showed that the only risk the market pays you for is the risk of the river itself, the part you cannot get rid of by spreading your money around. Everything else, the risk of any one company or one bet, is risk you are taking for free. Nobody pays you for it, because anybody could have diversified it away. It was such a strange idea that the journal rejected the paper the first time. He got the Nobel Prize for it in 1990.

Alpha

Alpha is the other thing. It is whatever you earn beyond the current, by rowing. Picking the right stocks, timing the turns, seeing what others do not. When the person in the nice office says they can beat the market, they are saying they can row faster than the river flows.

Some people can. But here is what nobody in the nice office will tell you: alpha is not a skill you have, it is a game you win against somebody. For you to row past the current, someone else has to row slower than it. Every dollar of alpha is a dollar someone on the other side of the trade gave up. So before you believe a promise of alpha, ask the only question that matters: who is on the other side, and why are they going to lose to you?

The arithmetic

In 1968 a young researcher named Michael Jensen decided to check. He took 115 mutual funds, the professionals whose job was to beat the market, and measured how much they earned beyond the river. The answer, on average, was less than zero. About one percent a year less, which was roughly what they charged. The rowers, as a group, had rowed the boat backward by exactly the cost of the oars.

That result has been repeated every decade since, in every market anyone has bothered to check, and it is not a mystery. Sharpe explained why in a short paper in 1991 that every investor should read once. Before costs, all the active investors in the world together must earn exactly the market return, because together they are the market. After costs, they must earn less. You do not need to have an opinion about anyone’s talent to see this. It is simple arithmetic, and no amount of skill in the room can change it. Most professionals will lose to the market, and they will charge you while they do it.

Then why does anyone try?

Because someone has to. This is the part that makes the whole thing interesting, and it comes from a paper by Sanford Grossman and Joseph Stiglitz in 1980. If nobody rowed, if everyone just sat in the boat, prices would stop meaning anything, because nobody would be doing the work of figuring out what things are worth. So the market has to pay a few people, just enough, to do that work. Alpha exists. It has to. But it exists in exactly the amount needed to pay for the research that produces it, and no more. There is no free alpha lying around, only alpha that someone worked for, and that someone else paid for.

Which brings us back to the nice office. When a manager charges you two percent a year, that two percent comes off the top every year, whether they beat the market or not. So for you to come out ahead, they have to beat the market by more than two percent, year after year, against every other professional trying to do the same thing. It happens. I have seen it happen. But it is rare enough that the honest starting assumption for any manager you meet is that they will earn the market minus their fee. They have to prove otherwise, with numbers, over years. The burden is on them, not on you.

What I do

I buy the river, most of it, as cheaply as I can. That is where most of the money comes from and where most of it will always come from. Then, when someone asks me to pay for alpha, I make them answer the Grossman and Stiglitz question out loud: who is on the other side of this trade, and why will they lose? If the answer is a name and a reason, I listen. If the answer is a chart of past returns, I say thank you and buy the river.

I have not always done this. I have paid for alpha more times than I would like to admit, and when I finally did the arithmetic, I found I had mostly bought beta at a high price with a nice person’s name on it. Everyone does this once. I had to learn it the expensive way. I am writing it down so you can skip that part.

With love,
Papá