In his latest memo titled – Fewer Losers, or More Winners?, Howard Marks explains how superior investing involves creating an asymmetry with more upside potential than downside risk, and alpha is the key to achieving this. Here’s an excerpt from the memo:
The last element I want to touch on is what I call “alpha,” or individual investing skill. The reason the EMH disdains efforts to beat the market is its conviction that since securities are always priced correctly, the ability to identify bargains to buy and over-pricings to avoid can’t exist.
Theory’s assertion that there’s no such thing as mastery of markets implies that no one has the skill to assemble portfolios that outperform. This is why I depict the bell-shaped curves above as symmetrical: In an efficient market, investors can only take what the market gives them.
But I’m convinced the potential to improve on that through skill does exist in some markets and some people.
Investors who possess alpha have the ability to alter the shape of the distributions in the graphs above so that they’re not symmetrical, in that the portion of the distribution representing the less desirable outcomes is smaller than the portion representing the better ones.
In fact, that’s what alpha really means: Investors with alpha can go into a market and, by applying their skill, access the upside potential offered in that market without taking on all the downside risk.
In my memo What Really Matters? (November 2022), I said the key characteristic of superior investing is asymmetry – having more upside than downside. Alpha enables exceptional investors to modify the probability distributions such that they are biased toward the positive, resulting in superior risk-adjusted returns.
If alpha is the ability to earn return without taking fully commensurate risk, investors possessing it can do so by either reducing risk while giving up less return or by increasing potential return with a less-than-commensurate increase in risk.
In other words, skill can enable some investors to outperform by emphasizing aggressiveness and some by emphasizing defensiveness.
The choice between these approaches depends on the type of alpha an investor possesses: Is it the ability to produce stunning returns with tolerable risk, or the ability to produce good returns with minimal risk? Almost no investors possess both forms of alpha, and most possess neither.
Investors who lack alpha shouldn’t expect to be able to produce either version of asymmetry – that is, to be able to generate superior risk-adjusted returns. However, most believe they do have it.
The proper choice between the two approaches – fewer losers or more winners – depends on each investor’s skill, return aspiration, and risk tolerance. As with many of the things I discuss, there’s no right answer here. Just a choice.
You can find the entire memo here:
Howard Marks Memo – Fewer Losers, or More Winners?
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