What is the difference between beta, smart beta and alpha when investing. Plus why it’s easier to be a successful investor by focusing on things that won’t change rather than trying to predict what will.
In this podcast, you’ll learn:
- What is asset-liability matching.
- What are key elements of Jeffrey Bezos’ strategy at Amazon.
- What is the difference between beta and alpha.
- What are index funds and why have they traditionally been capitalization weighted.
- What is the difference between beta and smart beta.
- What are fundamental index funds and what is their advantage over capitalization weighted index funds.
- What are portable alpha strategies
Focus On What’s Not Going To Change
I recently visited the Ohio town where I grew up. I go back every couple of years even though my family no longer lives there.
I like to see what has changed and what hasn’t.
The town is called North College Hill, and it resides about 10 miles north of downtown Cincinnati.
My father grew up there and was married at the local Catholic church, the same church where we held his funeral as well as the funeral of his parents.
Except for a couple years in Mexico and a semester in Utah, I lived there from ages 2 to 26, including the first two years of my marriage.
In short, North College Hill is my hometown, and I have been watching it change for over four decades.
The city is landlocked by adjoining towns so it is not expanding, and it’s not a hotbed of new construction so there are no teardowns of existing homes to make way for new ones. Most of the houses have been there for 75 years or more.
That is why I was shocked to find on this recent trip that the house my spouse and I rented when we were first married was no longer there. There was just an empty lot with grass.
A Thought Experiment
Here’s a thought experiment. If you went back 50 years in time to your hometown and had to predict what your town would be like 50 years later, how would you go about this task?
Jeffrey Bezos, founder of Amazon, said the following in a 2007 Harvard Business Review interview.
“When I’m talking with people outside the company, there’s a question that comes up very commonly: “What’s going to change in the next five to ten years?” But I very rarely get asked “What’s not going to change in the next five to ten years?” At Amazon we’re always trying to figure that out, because you can really spin up flywheels around those things.”
It is much easier when predicting to focus on what won’t change as opposed to what will.
If you went back 50 years in time and tried to predict what your town would be like 50 years hence, your best bet would be to focus on what hadn’t changed in the 25 to 50 years prior to the point in time when you are making the prediction.
Longevity Increases Predictability
The longer something has been around the more likely it will continue to be around decades from now.
The oldest thing in my hometown is a small cemetery on the corner of the busiest intersection. It includes the graves of Revolutionary War veterans. The second oldest thing is a white brick home built by Robert Cary in 1832. His father founded the town site.
I am quite confident those things will be around in 50 years.
Buildings, cemeteries and churches are likely to continue, but predicting which businesses will still exist in 50 years is more difficult. Commerce is more complex, dynamic and more easily disrupted than housing.
In my hometown, in the last 50 years there have been dozens if not hundreds of businesses that have come and gone.
There are only three that are still open for business in their original buildings fifty years later: A bakery, a tailor and a musical instrument store.
Predicting which business will survive decades into the future is a herculean challenge. Yet, active stock managers are not only expected to predict which companies will survive, but which will thrive.
When you passively invest through an index fund that contains hundreds of stocks, your success is not dependent on successfully predicting which companies will prosper.
Instead, success is dependent on certain things remaining in place. Namely, the continued existence of capitalism and long-term economic growth.
My recent visit to my hometown reminded me I’d much rather have my investment success dependent on what won’t change rather than what will.
Of course, that doesn’t mean there can’t be major events and trends that disrupt capitalism and transform the economy.