“Any individual decision can be badly thought through, and yet be successful, or exceedingly well thought through, but be unsu ccessful,
because the recognized possibility of failure in fact occurs. But over time, more thoughtful decision-making will lead to better overall results,
and more thoughtful decision-making can be encouraged by evaluating decisions on how well they were made rather than on outcome. “
– Robert Rubin, Former Treasury Secretary
The Forgotten Component of Return
Position Size + Stock Selection = Portfolio Return
Countless hours of research go into Stock Selection,
only to be nullified by inefficient Position Sizes that
are determined by instinct and mental calculation.
Alpha Theory™ creates a repeatable system to size
positions using a firm’s fundamental research.
Why use Alpha Theory™?
More than 95% of funds do not have their 5 best
ideas as their 5 largest positions. Why? Most firms do
not know what their 5 best ideas are.
To effectively construct a portfolio, a firm must have
a top-to-bottom view of asset quality that adjusts as
prices and fundamentals change. Alpha Theory™
creates a framework to measure every idea with riskadjusted return and points out, for instance, when
your research says you should have a 4.5% position
size and you currently only have 2.0% exposure.
Compare two equally skilled stock picking firms with
the same ability to analyze assets. The firm that
closely aligns position size with risk-adjusted return
will dramatically outperform the firm managing the
portfolio with mental calculation.
Effective Portfolio Construction
Money managers are in the business of selecting
assets that make money. However, they are not just
selecting one good asset; they are building a portfolio
of good assets. Maximizing the return of a portfolio
requires adherence to one simple tenet; the portfolio
must have the greatest exposure to the best assets
and the lowest exposure to the weakest assets.
The Alpha Theory™ Solution
Alpha Theory™ is a Portfolio Management Platform
that provides Research Management, Position Size
Optimization, Risk Management, Portfolio Analytics,
and Analyst Performance Measurement.
Command Center Platform. Alpha Theory™’s webbased interface provides a central place to manage
the entire firm's idea generation, analytical process,
and decision process, both current and historic, so
that they are always up to date.
Research Management. Alpha Theory™ creates the
optimal framework to capture and measure research
using upside target, downside risk, and probability of
each scenario. The scenarios combine to generate a
risk-adjusted measure of potential return.
Portfolio Optimization. Once the use of risk-adjusted
return is employed, Alpha Theory™ sizes positions
based on the assumption that higher risk-adjusted
return positions should have greater exposure which
creates a portfolio with the highest potential return.
Risk Management. Risk parameters specific to the
fund are factored into the optimal position size
including fund size, minimum and maximum long or
short position sizes, minimum and optimal riskadjusted returns, liquidity, market correlation,
portfolio exposure, sector exposure, analyst
exposure, analyst abilities, chance for extreme loss,
analysis confidence and investment time horizon.
Active Administration. Real-time updates enable the
firm to adjust position size quickly in response to
rapidly changing market conditions, asset prices and
fundamentals. Recalibration is the foundation of
maintaining an efficient portfolio.
Three Steps to an Efficient Portfolio
1) Create a discipline that requires every idea have a welldefined upside profit, downside risk and probability of each
before considering inclusion in the portfolio.
2) Use upside, downside and probability to calculate a riskadjusted return for every asset in the portfolio.
3) Make risk-adjusted return the anchor for portfolio
construction (i.e. higher risk-adjusted return equals a larger
position in the portfolio.)
Benefits of Risk-Adjusted Return Position Sizing
1) Improve returns – Empirical research and common sense
prove that risk-adjusted return position sizing is the
optimal way to maximize portfolio returns. Exposure goes
to the best ideas and the weakest ideas are pruned.
2) Reduce risk – Every decision is now made in the context of
downside potential. If downside risk increases, riskadjusted return falls, which equals a smaller position size.
3) Reduce emotion – Decisions can be made based on true
measures of risk-reward and are not subject to the bias of
mental calculation and heuristics.
4) Eliminate Confidence Bias – Analysts will search for
information that supports their thesis. Calculating riskadjusted return forces them to consider downside
potential, so the research improves because the analysts
consider all information, positive and negative.
5) Rational Trading – An adage of portfolio management is,
“treat every position like it is brand new every single day.”
Risk-adjusted return gives you an adaptive portfolio that
adjusts as prices and fundamentals change.
6) Includes Conviction Level – Two assets with the same
upsides and downsides are not always created equally.
Risk-adjusted return uses probability which allows for
comparison of assets with similar risk-reward.
Alpha Theory™ Contact: (866) 482-2177 •
[email protected] • [email protected]
Alpha Theory™ Information: www.AlphaTheory.com •
www.AlphaTheory.com/demo • blog.AlphaTheory.com
“Any time you make a bet with the best of it, where the odds are in your favor, you have earned something whether you actuall y win or
lose the bet. By the same token, when you make a bet with the worst of it, where the odds are not in your favor, you have lost something,
whether you actually win or lose the bet.” – David Sklansky, The Theory of Poker