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Three Sources of Alpha

Sanibel Captiva's Pat Dorsey on the three ways to beat the market--and the one that's most achievable for individual investors.

Jason Stipp: I'm Jason Stipp for Morningstar.

The market for the informational advantage, the alpha, the step ahead of the competition out there in the marketplace has become so competitive that some folks have bent or even broken the law to try to get a leg up on everyone else.

But how can you actually get some alpha and stay within the confines of the law?

Here with me to discuss that is Pat Dorsey. Pat is Morningstar's former director of equity analysis. He is now with Sanibel Captiva Trust, but a friend of Morningstar. I'm happy to be sitting down with him today. Thanks for joining me, Pat.

Pat Dorsey: I'm always happy to talk about how to make money legally.

Stipp: It's good to stay within the confines of the law when you can.

Dorsey: I'm down with that.

Stipp: You're going to be outlining three sources of alpha. The first one is related to the information that you have, and there's ways to that legally and there's ways to that not legally. Tell us a little bit about that number one source of alpha.

Dorsey: This comes from a wonderful paper by Russell Fuller, of Fuller & Thaler, the well-known asset management shop and one of the founders of behavioral economics, called the Three Sources of Alpha. The first one is having an informational advantage, as you had mentioned--knowing more than the other guy.

I would say that in small caps you can do this. Even as a small investor, if you're diligent and you work hard on a smaller business, they are not very well followed by Wall Street; they are not very well owned by money managers. So, you can get to know them a little bit better than everybody else, but for the kinds of stocks that Raj Rajaratnam was trading, the informational advantages only come in less than legal ways.

But critically, I would say that generally informational advantages don't exist outside of very small companies.

Stipp: OK, so the information that you get, that could be one advantage that you have. What you do with that information obviously could be the source of another advantage.

Dorsey: So the second kind of alpha that Fuller posits is have an analytical advantage. Basically, you see this with quant people a lot: "I have a model that processes data better than everybody else, and it comes to more accurate conclusions about where security prices will go." That's typically the way you think about an analytical model.

The problem is, these analytical models get copied. Everyone is trying to do something ... is operating with similar information. So if you've got a really smart quant model, the odds are good that it's probably going to get copied in time, and so again, I would say, like an informational advantage, analytical advantages are also pretty hard to come by.

Stipp: The third one has a lot to do with your temperament as an investor. It is something that we like to listen to Warren Buffett to remind ourselves of this. But sometimes it's hard to put into practice. What's another way, then, that you can get that leg up?

Dorsey: So, the third one that Fuller talks about--and I think this is really where the money is made, to be frank--is having a behavioral advantage. So it's not what information you have, it's not how you process that information, it's what you do with it once you have it and process it. And that is just about basically behaving a little bit more rationally than everybody else. In the famous Warren Buffett words, being fearful when others are greedy, greedy when others are fearful. Being aware of recency bias, being aware of anchoring. All the various things that we talk about in the behavioral finance literature.

But the reality is that, simply acting a little bit more rationally than everybody else, having that behavioral advantage, I think is a far more achievable source of alpha than actually out-thinking everybody else, because there's a lot of money, a lot of computing power, even a lot of shady tipsters being thrown at trying to get more information than the other guy. But if you just kind of sit back and say, can I just behave a little bit more rationally? I would say that's pretty achievable given how irrational the market can be.

Stipp: A lot of good advice, especially for the individual investor. Pat, thanks so much for joining me today.

Dorsey: Anytime, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.