Gambling returns have no alpha

Many have been perplexed by the ups and downs of financial markets, disconnected from the real markets. Some may argue that the recent rise in the value of the financial assets has been predictable from analyzing the trends – technology waves, slow-down in foreclosures and other such metrics. Many such analyses describe why profits could rise in the future but point out the risks of them not materializing. Some are sure of the end outcome but unsure of the time it may take.

Extrapolating real market trends into financial markets is dangerous as known information generally do not produce trends. If a trend is seen in the financial markets, it is generally driven by artificial liquidity – money chasing money. Such trends have a tendency to break catastrophically. For example, some may argue that they could have easily predicted Apple’s stock price rise – driven by its popular iPhone platform. What they are forgetting however is an important aspect of investing. If one bought Apple at a low price just a few months ago and made a handsome profit, it is because she was gambling and some win in gambles, sometimes. When one buys a stock, however, she also buys the risk of the stock not performing. For technology companies such risk is high. Apple could have easily gone down if its new technology platform were not a hit.

Making money in the stock market is not rare but doing it consistently is. Large amounts of money can be made by taking commensurate amounts of risk. Risk adjusted excess return, alpha, however has been fleeting.