Three Sources of Alpha: Informational, Analytical & Behavioral ~ market folly

Monday, April 2, 2012

Three Sources of Alpha: Informational, Analytical & Behavioral

We're compiling more articles on the timeless educational aspects of investing and thought this was worth highlighting. The three sources of alpha is a concept explained in a paper by Russell Fuller of the asset management firm, Fuller & Thaler.

In an old interview with Morningstar, Pat Dorsey of Sanibel Captiva Trust talked about the three sources of alpha and provides a brief overview.

1. Informational: "Knowing more than the other guy" (legally, of course) can provide quite an advantage. He references small caps where sell side coverage is scarce as a prime example. In the digital age of quickly disseminated information, these advantages are harder to come by outside of lesser known companies.

2. Analytical: This is the quantitative side of things and comes down to modeling out scenarios and the various conclusions drawn. Over time, these advantages can dissipate as others copy models etc.

3. Behavioral: The third advantage is the one Dorsey argues is where the most money can be made. He says it's not how you process the information, but it's what you do after you've processed it. If you can act more rationally than others, this can be a more achievable source of alpha over out-thinking others. As Warren Buffett says: "Be fearful when others are greedy. Be greedy when others are fearful."

For more on this topic, be sure to check out hedge fund Blue Ridge Capital's recommended reading on behavioral finance.

The video interview on the three sources of alpha is embedded below:

H/T PragCap

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