Adding Value

The purpose of this chapter is to explain what it means for skillful investors to add value.

First let’s understand the two terms from investment theory:

• Beta: a measure of a portfolio’s relative sensitivity to market movements.
• Alpha: personal investment skill, or the ability to generate performance that is unrelated to the movement of the market (this is alpha as defined by Howard).

It is easy to achieve the market return by holding a passive index fund.

All equity investors start with the possibility of simply emulating an index.

Pro-risk, aggressive investors should be expected to make more than the index in good times, and lose more in bad times.

The formula for explaining portfolio performance (Y) is as follows:

Y = A + BX

A is the symbol for Alpha, B stands for Beta, and X is the return of the market.

The market-related return of the portfolio is equal to its beta times the market return.

In my opinion, superior returns come most dependably from buying things for less than they’re worth and benefiting from the movement of price from discount to fair value. Making money this way doesn’t require increases in intrinsic value, which are uncertain, or the attainment of prices above intrinsic value, which is irrational.