You can think of your ability to generate alpha as the product of two variables:
- Design. The quality of the design of your investment process.
- Discipline. The consistency with which you follow that process.
The one without the other is not half as good, it can be a disaster. If you have designed a great process but you don’t stick to it, that design is merely an intellectual abstraction made grotesque by alpha-destroying actions. And if you are spectacularly disciplined about following a flawed process, you’re just being disciplined about destroying alpha. Neither of those is good.
At its simplest, the quality of your design is a function of your ability to identify and incorporate your competitive advantages into your investment process, so that you have a reasonable chance of generating alpha.
Your competitive advantages can broadly take two forms:
- Hard Edge. This might be something that you know and that others don’t. It could be informational or computational in nature.
- Soft Edge. This would be something that you do and that others don’t or won’t. This would be psycho-behavioural in nature.
Inevitably, your process-design reflects a style of investing, be it value or growth or whatever, and each of the many styles requires a different flavour of investment discipline. Each style requires that you do different things at different times in different ways. Each style makes different psychological and behavioural demands on you.
For example, your process might be designed to capitalise on your variant perception as a contrarian value investor, which would lead you to construct a portfolio with high active-share. But when you construct a portfolio that looks very different to the market portfolio or your benchmark, you’re starting an argument with an entity that’s more muscular than you are. A polite disagreement with conventional wisdom, as reflected by the market, can easily escalate into a fight to the death.
Given that there is a decent chance of this happening at some point in time, you’d be well served by first having made an accurate assessment of your tolerance for pain before picking the fight. If you haven’t done so, you’ll have incorporated a fatal flaw into your process-design. Once your pain threshold is breached, your discipline will go out the window and your process will be rendered ineffectual at best. It’s perfectly legitimate, and even courageous and noble, to pursue high levels of alpha through high active-share, but the pursuit will inevitably bring with it high levels of noise. You can hedge at least some of this risk.
You can start by gaining clarity on what flavour of discipline is implied and required by your chosen investment style and process. You can have a decent stab at assessing the ability of your team, with its unique psycho-behavioural profile, to stick to your investment process under conditions of elevated noise. You can try to figure out what your pain threshold is, and make a plan for what you’ll do when noise pushes you into your danger zone.
Yes, this looks like work. And no, it probably won’t be much fun. But the cool part is that your competitors are unlikely to do it for those exact reasons. And when you do something valuable that your competitors don’t or won’t, you have gained a psycho-behavioural edge.
- What flavour of discipline is implied and required by your investment style and your specific process?
- What is the ability of your team, that specific collection of individuals, to stick to your process under conditions of elevated noise?
- What is your pain threshold? What do you plan to do before you are pushed into your danger zone?