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Alpha Theory Blog - News and Insights

December 29, 2021

A Lack of Freshness Spoils Returns

 

Alpha Theory can’t tell you how to do your research, but it can tell you when. Using insights from the Alpha Theory All-Manager dataset, we can provide guidance on some of the basics in managing your research process. 

 

Managers understand intuitively that producing investment research and updating that research regularly (i.e. freshness) is important. But how frequently? Should I update my research every 60 days? Every two weeks? Do I need to produce scenarios for all my positions?

 

Key conclusions: 

1. Assign price targets and probabilities to every investment

2. Update them once a month

 

To determine the impact of freshness and coverage on returns, we measured the one-year forward return for the optimal long portfolio for each fund in the Alpha Theory All-Manager dataset on a quarterly basis1. We then put each fund into four buckets based on their average freshness (days since the last update or DSLU) and coverage (percentage of positions with price targets). Next, we calculated the return of each quartiled bucket to see if returns correlated to freshness and coverage.

 

We found that funds that were diligent enough to place in the top quartile produced more than four times as much alpha as the bottom quartile, increasing monotonically from bottom to top. The median update frequency for the top quartile was 25 days (once a month updates), meaning the top funds updated more than 10x as often as managers in the bottom quartile. Additionally, managers in the top quartile had research on all active positions.  

 

A Lack of Freshness Spoils Returns

 

As a fundamental manager, you may argue that very rarely does something meaningful happen every 30-days that warrants a forecast update. We would counter that price is an important signal. For example, let’s say you initiated coverage on a position at $100 with a 70% chance of going to $150 and a 30% chance of going to $50. If the price moves from $100 to $125, wouldn’t you say the probability of reaching your bull target has changed? While $150 may still be the price suggested by your model, updating the probabilities of your scenarios to more accurately reflect likely outcomes allows the OPS model to make better sizing recommendations.

 

In addition, Daniel Kahneman’s new book “Noise” describes how the same expert can take the same information and come to different conclusions at different times. And, that the best answer is the average of those forecasts. This means that an analyst may come to a different conclusion for price target and probability on a different day and that the constant refinement (updating once a month) is healthy and leads to more accurate forecasts.

 

Finally, research from our friends at Good Judgement Inc. shows that over the past six years, their top forecasters (orange) update roughly 4x as often (11 updates vs 3 updates per question) as non-Superforecasters. Update frequency has a high correlation with outperformance and incorporating even small additional bits of information (Superforecaster updates were roughly half the size of non-Superforecasters) that either support or detract from the probability of a given outcome lead to better results over time.

 

A Lack of Freshness Spoils Returns Chart 2

 

We are always interested in learning more about your research process and where Alpha Theory can help. Alpha Theory is a process enhancement tool, creating a space that systematizes how you conduct and use research for allocation decisions. Please reach out to us with any questions so we can better optimize your workflow to generate more alpha.

 

1To normalize for different benchmarks, we calculated alpha on an idio+sector basis using the Axioma World-Wide Equity Factor Risk model, which removes performance derived from all their tracked factors, excluding sector. 

 

November 29, 2021

Getting Comfortable with Many, Micro Updates

 

For years we’ve worked closely with the folks at Good Judgement Inc. from “Superforecasting” fame. One of our friends there, Chris Karvetski, recently published a white paper called “Superforecasters: A Decade of Stochastic Dominance” on Superforecasters’ attributes and skills. For analysis, Chris studied 108 forecast questions with 167,000 forecasts to compare the differences between accuracy and approach between Superforecasters and everyone else.

 

From an accuracy perspective, Superforecasters dominate with accuracy that is 36% better (0.166 error for Superforecasters versus 0.259 for general forecasters).

 

Picture1

 

Alpha Theory clients forecast stock price movement. As such, the question we should ask is “how can we be more like Superforecasters?” Well, Chris broke down the frequency and magnitude of updates and I believe the answer is clear.

 

Picture2 Picture2

 

Superforecasters update their forecasts ~4x more often which leads them to adjustments that are about half the size. Imagine steering a boat towards a lighthouse. You can choose to make 3 major adjustments or 11 minor adjustments. Which method is going to get you closer to the lighthouse?

 

As analysts, to gain better forecast accuracy, we should frequently update our price targets and probability forecasts. Obviously, new information warrants updates but we should still make updates even when there is no new information. As The Verve says, “we’re a million different people from one day to the next.” We all have what Daniel Kahneman calls, Occasion Noise, which basically means that we change our opinions without the facts changing. Our mood impacts our forecasts. To get a truer sense of our own opinions, we should ask ourselves the same question at different times.

 

Let’s be like Superforecasters and get comfortable with many, micro updates. In our next blog post, we’ll explore the impact that update frequency has on returns.