Behavioral alpha is the excess return that an investor earns by being well behaved. Extensive research has shown that the vast majority of more active investors fail to beat the market. The arithmetic of the market confirms this as we know that the average less active investor must outperform the average more active investor after taxes and fees. Behavior is the most important aspect of relative activity as an investor who is excessively emotional will tend to be more active thereby resulting in higher taxes and fees across time.
Behavioral alpha can be maximized in the following ways:
- Targeting the appropriate portfolio instead of the optimal portfolio.
- Having realistic investment expectations.
- Building reasonable financial goals across realistic time horizons.
- Establishing a personalized understanding of your risk profile.
- Constructing a portfolio that is likely to establish those goals within the proper context of your risk profile.
- Understanding the alpha paradox and ditching Wall Street’s sales pitch that sells the hope of market beating returns in exchange for the guarantee of higher fees.
- Sticking with the plan.
Interestingly, actual alpha or excess return, is never a financial planning goal despite the fact that most investment managers and investors try to “beat the market”. In attempting to do so they often exacerbate the potential for behavioral risk by creating a conflict of interest between the returns they want and the returns they need and are comfortable with.
Investing, much like good health, is simple in theory but difficult in reality. Discipline and a sound portfolio construction process will be the difference between financial success and failure. And those who achieve behavioral alpha will tend to outperform those who try to achieve market alpha.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.