Han Dieperink: Timing is the only source of alpha
Han Dieperink: Timing is the only source of alpha
This column was originally written in Dutch. This is an English translation.
By Han Dieperink, written in a personal capacity
Timing is crucial in generating alpha. However, here lies the risk that the fast and intuitive part of our brain makes the wrong decisions.
The human brain consists of two systems: the fast system and the slow system.
The fast system works based on intuitions and emotions and makes full use of prejudices and rules of thumb. It isn't logical, yet it is responsible for as much as 95% of daily decisions.
The slow system works based on logic. The information is weighed and various options are considered, which takes a lot of time and energy. The fast system often continues to run in the background.
Financial markets are perfectly capable of activating the fast system. It sometimes seems as if financial markets are designed to benefit as many participants as possible. Financial markets may be efficient, but humans are not.
Timing is crucial
Timing is the only source of alpha. All other sources of alpha have been identified, making it a beta variant. Leaving aside the question whether something like this should be seen as an anomaly, or whether it is caused by behavioral biases: explainable alpha is ultimately nothing more than beta.
Timing is also simple. It's nothing more than buy low, sell high. Yet the fast system appears to mainly make decisions that destroy value in terms of timing. When the market is high, investors enter en masse and in times of stress many investors exit. It is herd behavior that may have been useful on the savannah in the past, but actually gets in the way when investing. That is also why contrarian investing works: going against the crowd or consensus often also means going against intuitions and emotions.
Every investor is concerned with timing, because even the decision to stay put is a form of timing. In addition, every investor also makes a selection of investments.
Strangely enough, the results of many passive investors differ even more than those of active investors. The concept of 'market' can be defined in completely different ways. The consensus among active investors about what the market is is apparently greater than among passive investors. Apparently the fast system also wins in determining the benchmark for passive investors, which is determined more intuitively.
Bull markets and bear markets
There are two types of corrections in stock markets: bull market corrections and bear market corrections. A bull market correction is typically a correction of about 10%. Fundamentally nothing has changed and such a correction is intended to let off steam. The prices have run a bit too far ahead of the fundamentals and it is time to slow down. Especially after a long (uninterrupted) period of rising prices, investors become afraid of heights. That is nothing more than the intuitive brain that has apparently recognized a certain pattern (continuous increase without correction) and on that basis dares to predict that a correction will occur. The biggest risk of investment committees is that this intuitive warning of danger causes the consensus herd to move. After all, we are all human.
Bear markets are caused by fundamental changes. These are rational, so they can be analyzed using the slow system. A bear market is also defined as a decline of 20% or more. Unlike bull market corrections, where you have to time well twice (out and back in, with the risk of missing the further upward movement), it pays more to time it in bear markets. That doesn't mean it's easy, but an advantage of rational arguments is that they can be thought about. In fact, every investment decision is a good one, as long as it has been thought through.
Timing and asset allocation
Timing is not only a matter of timing when choosing whether or not to enter, but in every consideration between one investment and another. The big advantage is that in such a trade-off, investors are more or less forced to use the slow, rational system. Moreover, a lot of brainpower has already been incorporated into the prices. Investors are not alone and the price of a particular investment has been determined thanks to the efforts of a large group of investors, something that passive investors benefit from as 'free riders'.
It therefore makes sense to consider what the slow system sees that the market does not, or howone can rationally profit from the fact that in a certain market intuitions, emotions, and – as a result – herd behavior have gained the upper hand. That is not easy, because here too we are all human after all, and alpha is fleeting.
The artificial brain
Today, investors are getting support from artificial intelligence. With the help of AI assistants, we can make our slow rational system work much faster. While the human brain cannot store all the data, this is no problem for the artificial brain. Because the artificial brain is not human, it can also better identify and possibly even predict the errors of the fast intuitive brain. The result is that the market will become even more efficient due to this extra brainpower. The market may change as a result, because in addition to the fast and slow brain, there is now also the artificial brain.