Friday, September 16, 2011

Measuring Alpha


Alpha, What Is It? 
e have all heard the term alpha as it relates to finance. The term has come to the forefront recently courtesy CNBC s well-advertised Delivering Alpha Conference, and of course, by way of the popular financial website Seeking Alpha. 
What does alpha mean relative to finance? In short, alpha is a technical risk ratio used in modern portfolio theory. 
Simply stated, alpha represents what a portfolio manager or investment strategy adds to or subtracts from returns relative to the baseline performance achieved by a benchmark index such as the S&P 500. 

A positive alpha of 1.0 means the fund or strategy has outperformed its benchmark index by 1%. Correspondingly, a similar negative alpha would indicate an underperformance of -1%.
Today as promised, I am going to share with you a snapshot measure of my long-term investment strategy delivering an alpha of 720 during one of the most uncertain economic environments in the past 50-years. 
In a previous article, I discussed the common human condition of reacting to the present vs. deriving wisdom from the past. Well, it should come as no surprise that the majority of Traders and Investors suffer the exact same malady of reacting emotionally and reflexively to the current market conditions vs. employing a precise and preconceived plan of action. 
I also compared the current uncertain economic and investment environment to that of a similar and arguably much more severe 16-year period, which ran from 1966 1982. Moreover, I had explained that to navigate effectively during such times, that one must re-adjust expectations accordingly and develop the tenacity and the will to prevail. 
Granted, what I describe in the previous paragraph is far easier to articulate than to actually accomplish.

How Does One Accomplish This? 
Obviously, one must have a preconceived and trusted strategic plan of action (or strategy) in place that will alert them to respond accordingly to ALL market conditions BEFORE THEY OCCUR. 
HELLO readers, these precise strategies of adept preparedness are exactly what I have developed, historically back-tested, and currently employ in real-time. 
Take a close look at the measuring alpha chart provided and observe my strategies long-term engagement tactics throughout the course of the last bout of uncertainty from 1966-1982.  In the 16-years spanning 1966-1982, the S&P 500 traded within a wide 126% range from 62.68 on the low end, to 141.96 on the upper. The measuring alpha chart begins on February 11, 1966 at a price of 94.06, and concludes some 16-years later at a price of 101.44 during the week of August 13, 1982. 

The Results  (Machines Don' t Lie Folks) 

From start to finish, and despite the 126% range, after 16-years of turbulent bull and bear markets the benchmark S&P index advanced a paltry 7.84% - in 16-years!That translates to a severely sub-standard annual rate of return of roughly 0.5%, which is an exceptionally easy benchmark to beat from an alpha perspective. 
Over the same time frame, my strategic approach delivered 65.74% in Total Returns and captured 63% of the entire trading range for the period.Bear in mind that this performance measure does NOT include the 35.25% return resulting from the previous bull market; instead, it begins with the 9.35% loss on short positions taken in March of 1968 and ends with the 21.2% profit taken on long positions in September of 1981.Of the 8 position shifts taken over the 16-year period, only 2 resulted in losses, and the remaining 6 were profitable shifts in long-term investment bias. 
These statistics translate to a 75% win rate on long-term directional shifts, which produced a profit-measured win-to-loss ratio of nearly 3-to-1.As an aside, the historical annual rate of return for stocks is around 8%. During this prolonged 16-year period of extreme stress, wild swings of abrupt bull and bear markets, my strategy delivered an annual rate of return of 4.10%, more than half the historical average vs. the sub-standard 0.5% derived from the benchmark itself. 

Not only does my strategy ride the certainty of powerful bull markets with ease, but it also traverses the gray skies of prolonged uncertainty with the grace of a gazelle. Mission Accomplished - Next. 
This and other strategies, which I have designed for different timeframes, markets, and objectives, are currently at work in today s markets and continue to perform remarkably well. 
Trust me, as the equity curve attests; though it looks easy and painless after-the-fact, maintaining the discipline to heed the signals and endure the open trade drawdowns is far more difficult than sticking ones head in the sand and just hoping for the best. 

Three Poor Long-Term Options 
The following are three common mistakes made by investors and traders alike:
  • They freeze like a deer in the headlights, do nothing, hope for the best, and take comfort that they are not alone. Hope in concert with the paralysis of denial is a strategy doomed toward complete and utter failure. 
  • They sell everything near a market high, go to cash, disengage, and rest assured that they are preserving capital knowing that their money will stagnate until they put it back to work. Feeling brilliant, after a big drop in prices, the markets come back, so they think it is safe to get back in. Shortly after they do, the market begins to tank again - now they are back at square one. They continue repeating this process until they give up all together realizing they have done no better than if they had left well enough alone. The old adage is true; you CANNOT time the market, not that way anyhow.
Last and the very worst is that...
  • They hang on until they can no longer stand the pain, and then they sell everything near a market panic low. OUCH!
If you find that you are making any of these common mistakes, wish to Part Company with the masses, and distinguish yourself and your investment accounts as alpha-enabled, then join us as we continue to navigate successfully amid this challenging period in market history. 

Next: Breaking Up With Netflix 
In closing, there is a whole lot of news surrounding the pounding that Netflix is taking of late. As you may know, Netflix is part of my portfolio. In a future article, I will share with readers the complete history of my engagement with Netflix, which will illustrate how my tactic of strategic diversification rules the day - even amid market environments with 90% plus correlation to the S&P. 
Until then, 
Trade Better/Invest Smarter
Joe Russo aka ~ the PILOT
Publisher and Chief Tactical Strategist
Elliott Wave Technology 

Elliott Wave Technology provides a suite of Winning Solutions designed to assist those who wish to trade better and invest smarter based upon the practice and deployment of proven trading strategies in concert with expert and unbiased chart analysis.