Emphasize risk premium over alpha

If I want to start a business but don’t have enough capital, I can raise the funds in two main ways. Bonds and stocks offer different rights and obligations. Their expected return is above that of the risk-free investments. (For now, let’s leave aside the question of what exactly counts as a risk-free investment, or if it even exists.)

The risk premium is the extra return you get over a risk-free investment. It’s always positive on a forward-looking basis. Otherwise market participants would sell until the positive risk premium is restored. The key feature of the risk premium is that it’s unconditional. Investors don’t have to meet any special requirements to earn it. Even my grandma's global equity portfolio earns more than a risk-free return in the long term.

When someone earns more than the market average return, we say they’ve generated "alpha." That’s why there’s so much competition among investors to achieve alpha. But unlike the risk premium, alpha is conditional. From a client’s perspective, it depends on two things. First, the professional investor must have some kind of advantage over others. Second, the client needs the ability to find these exceptional investors. While neither of these tasks is impossible, both theory and experience show that the odds are not in our favour.

Thus, a solid investment strategy should focus on capturing the risk premium. Any return above that would be a pleasant bonus. A globally diversified portfolio is the easiest way to capture the risk premium. Align the portfolio with one’s risk appetite. Don't forget to diversify across asset classes and currencies.