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Buffett and Chasing the Ever-Elusive Alpha

NEW YORK (TheStreet) -- Humans have been repeating this inefficient ritual for more than 700 years, beginning in Europe. There sprung lenders and insurers who assessed the relative merits of individual commercial risk. The methods were somewhat more crude vs. the resources available to people today, but nonetheless this is the humble birthplace from which modern investment speculation gets its origin.

What should be the effective interest rate to lend an emerging company wanting to complete a construction project? What should an insurer charge to protect a ship setting sail into an stormy ocean, so that the premium pricing is profitable yet competitive?

Over time, more information was made available concerning those who needed capital market resources. And more ordinary people were able to invest in companies and products. Through the distribution of personal wealth and technological progress, society experienced episodic bouts of speculations and manias. Converting defined benefit plans in the U.S. to one where American workers invest their own contributions made for even greater heterogeneity of outcomes in the individual pursuit of alpha.

How can this progress be good, if there are fewer risk-adjusted beneficiaries?

Let's explore the outcomes and difficulties in the great inefficient search for exceptional alpha.

The true statistical test for outperformance relative to a highly liquid and investable benchmark takes into account how likely such performance could have been attained by luck alone. After all, over any period of time, there will separation in the performance of individual stocks within a basket. Some lucky stock holders will own specific stocks that uniformly outperform the underlying index over this same period of time.

Nonetheless it is worth noting that the difficult statistical standard necessary to show skill over a long career or life has a smaller side effect.

Only a minority of those who speculate will actually have, through skill, statistically outperformed.

Let's show how this works, using the time since the recent financial crisis as a baseline frame for analysis. From there we'll expand to a broader set of applications and time frames. The market has gone through a large hockey-stick pattern since the height of the financial crisis, five and a half years ago. Equity markets initially plummeted through early 2009, but have since rallied to new highs.

If you and your friends all tried your hands at stock selection and market-timing along the way, then there is a good chance that you are now feeling pretty good right now. Making money is fun, and so is the emotional confidence that inflates disproportionately to one's portfolio. But for the vast majority of people, feeling too good is unwarranted. And hubris should be replaced with humility in the great amount of luck that explains their post-crisis performance.

How likely is it that an investor (or speculator) in U.S. equities over the past five and a half years has demonstrated significant investment skills in this asset class? For our test we reduce the investable universe to a mapping of the current 30 Dow Jones Industrial Average (^DJI) stocks. And we ask what would be the performance of selecting a basket of any of the top quarter of these 30 stocks for each of the past five and a half years. So the top 8 stocks had an outperformance of 1.2%, with a 0.5% standard deviation. This implies a significantly low, 1% chance of straying that far from the rest of the DJIA by chance alone.

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