Alpha? Why Beat the Market?

Who want's to beat the market anyway? It's like a dog chasing its own tail!

Seeking Alpha: The dog that chases its own tail

Chasing the Wrong Goals

Ever watched a dog chase its own tail? It runs in circles, exhausting itself in pursuit of something that always stays just out of reach. Investors do much the same thing when they chase Alpha¹.

Anyone trying to beat the market year after year is on a fools errand and destined to fail.

The dream of outperforming the market is alluring. But this pursuit leads down a risky path that jeopardizes wealth creation.

Investors should be focused on the people running the businesses in which they are invested, not on the short-term performance of other traders in the market.

This sentiment will appear odd to most investors who have been programmed to think in terms of alpha and beta - but let’s dive in and see if we can’t reprogram some minds.

Upside-Down Thinking

Many investors view active management as a strategy where fund managers handpick stocks to beat a benchmark index, like the S&P 500. This involves constant research, analysis, and trading to capitalize on market inefficiencies. Conversely, passive investing is often seen as having exposure to the entire market - a supposedly safe, diversified approach requiring minimal effort.

But this framing is flawed.

Passive investors don’t have a well distributed exposure to the entire market. Instead they own an artificially constructed basket of companies that shifts according to methodologies that encapsulate variables like market capitalization or free float. Such variables are mostly momentum driven and therefore reflect the prevailing narrative and psychology of the market rather than the fundamentals of the underlying businesses. This would be fine if markets were efficient and able to correctly and recurrently reflect future events in current prices, which is simply not the case, at least in the short-term.

Arbitrary Benchmarks

Professional money managers charge fees to outperform the index, known as achieving Alpha.

However, a handful of companies have disproportionately driven recent S&P 500 gains, fueled by social media hype, passive investing, zero-interest rate policies (ZIRP), Quantitative Easing (QE) and excessive stock buybacks.

All of this results in artificial levels of demand which have arguably distorted market indices. With close to 40% of the index made up of 7 companies and the remaining 493 accounting for the residual 60%, the index is not truly representative of the performance of the underlying economy.

This raises an important question: why try to beat such an arbitrary and flawed measure?

The answer, of course, comes down to opportunity cost. If one can’t outperform the benchmark, investing passively in the index seems like the rational choice.

But this simple way of thinking focuses too much on short term, not enough on the underlying quality of each business in the index and takes no account of time frames.

The Power of Patience and Discipline

Imagine you're managing a pension fund. Your performance is steady - never spectacular, never disastrous. Over 14 years, your fund consistently ranks in the second quartile, fluctuating between the 27th and 47th percentiles. Nothing flashy, right?

And yet, over the full period, your fund lands in the 4th percentile. Near the top. How? Discipline. This isn’t a fictional case, this is the actual performance of the General Mills’ pension fund over a 14 year period.

Most investors sabotage themselves by chasing short-term gains, making emotional decisions that lead to costly mistakes. The best investors understand that long-term success isn’t about winning big every year - it’s about avoiding catastrophic losses.

Let’s put it to the test: If I offer you two portfolios - one with high risk that typically returns 18% per year, and another with lower risk that earns 10% - which would you choose? Most people would go for the 18% return. That’s the mistake.

Here’s why: A single bad year can erase years of gains. A portfolio growing at 18% annually doubles in four years. But if the fifth year brings a 50% crash, you’re back to square one - five years wasted, just like a dog chasing its tail.

Meanwhile, the investor who plays it safe with steady 10% returns finishes that same five-year period up 61%. That’s exactly how General Mills’ pension fund was managed - by prioritizing stability over chasing short-term wins.

Now, if I ask you again: Would you prefer the high-risk, high-return portfolio or the lower-risk, steady-growth option? Hopefully, you see the value of the latter. But here’s the catch - you have to accept that in many years, you’ll underperform the market. That’s the price of long-term success.

Most fund managers obsess over short-term alpha, mainly because their top priority is growing assets under management (AUM) and preventing draw-downs of capital among their fickle and uninformed investor base. To keep up appearances, they aim to outperform the market every single year - an impossible feat. This relentless focus on short-term results is exactly why most fund managers struggle over the long run. Their approach stands in stark contrast to that of the General Mills pension fund manager, who prioritizes long-term success over short-term victories. True outperformance isn’t about winning every battle - it’s about ensuring you don’t lose the war.

Warren Buffett understands this better than most. In 2007, he placed a $1 million bet that a basic S&P 500 index fund would outperform a selection of hedge funds over a decade. Ted Seides of Protégé Partners took the challenge, assembling a portfolio of hedge funds to compete. While some of these funds had standout years, Buffett knew their obsession with annual returns would ultimately be their downfall - (their high fees and the frictional costs of churning their portfolios further dampened their performance). Sure enough, before the ten years were up, Seides conceded defeat. Buffett’s index fund had come out on top, and his winnings went to charity.

Black Swans Are Not As Rare As You Think

Since 1928, there have been at least 22 bear markets in the S&P 500, with large double digit drawdowns occurring every 4–5 years on average. Experienced investors have lived through many of these - 1997 (Asian Crisis), 1998 (Russian Crisis), 2001 (Tech Bubble), 2007–2008 (GFC), 2011 (European Debt Crisis), 2020 (COVID19), 2022 (Inflation Scare)..

Another major correction is inevitable. It will likely come unexpectedly, triggered by an unforeseen event - hope for the best, but be prepared for the worst - that way you’ll avoid being caught with your pants down!

“Prioritize the downside of every investment. With limited downside, the upside will take care of itself.”

Howard Marks

Prepare in advance by actively building a portfolio of exceptional businesses designed to weather storms and thrive in the long run. Don’t chase vastly over valued momentum stocks in the hope of outperforming the market this year, think about your performance over the next 10 years.

Focus on holding a concentrated portfolio of high-quality businesses, with sustainable high returns on capital, run by trustworthy management teams and acquired at fair valuations. This approach isn’t about maximizing returns relative to an index over a set period; it’s about managing real risk across decades of economic cycles.

Indexing offers no protection because spreading investments across a wide range of assets doesn’t lower risk. Owning hundreds of businesses - many of which barely generate returns above their cost of capital - does not protect wealth. When the next bear market comes, the index will be hit hard as any excess reflected in valuations is purged from the market.

“The whole secret of investment is to find places where it’s safe and wise to non-diversify. It’s just that simple. Diversification is for the know-nothing investor; it’s not for the professional.”

Charlie Munger

Capital Preservation and Long-Term Growth

The principle is simple: You can only invest for the long run if you can survive the short run.

This means accepting that when markets are euphoric and risk appears low, your portfolio might underperform a broad index filled with lower-quality companies. Be okay with that.

You’re not playing short-term games where hype outweighs fundamentals and beating the market each year is the ultimate prize. That approach leads to risk-taking behaviour that will not end well.

Ensure that your stock selection is geared towards reducing risk, not enhancing it! Look for those rare businesses that will protect your wealth when the world looks terrible, which it inevitably will from time to time. These companies will generate abnormal returns when they have the wind at their back, but equally as important, they will take advantage of the tough times to consolidate their market position when their competitors are struggling, ensuring even better performance when the good times return.

Any business can have a great five year run during which they crush all expectations, but very few businesses are set up or have the resiliency to thrive when the economic cycle turns against them. Businesses that surprise everyone to the upside when the times are good often suffer the most when times are bad - in an effort to keep the good times rolling they tend to make bad decisions leading to value destruction.

In other words, its not about playing market cycles, which in the short term are more about emotions than fundamentals. Instead, its about deploying capital to generate returns through economic cycles.

The best investors don’t chase outsized returns at any cost. They seek opportunities where the downside is minimal - prioritize capital preservation and disciplined decision-making, even if it means sacrificing short-term gains.

1. Alpha (α) is a term used in investing to describe an investment strategy’s ability to beat the market.