If you think what I'm about to tell you sounds too good to be true, I don't blame you. I was once a skeptic, too.
And I've been at this game quite a while. That includes five years holed up with a "quant" geek who couldn't flip a sofa cushion without finding "alpha." Yeah, yeah, I know what you're thinking …
What the heck is alpha?
Without digging myself too deep a hole, "alpha" is the excess return you're earning on your stock portfolio above what some academic would expect given its level of risk. Put another way, alpha is the measure of your ability to pick better stocks than I can.
It's also the driving force behind a $1 trillion hedge-fund industry. Kind of remarkable, given that I vaguely remember paying nearly that much for some wise guy to teach me that alpha doesn't even exist.
And I believed it. Sure, I'd seen investors beat the market. But I'd also seen others get crushed. There just never seemed rhyme or reason to it all. Chet Hammersmith would get a hot hand for a year -- and then get his head handed to him the next. And so it goes in an efficient market.
Now it gets good …
So when my friend David Gardner started telling me he'd captured the ever-elusive alpha -- and that he'd hired a NASA scientist to prove it -- I barely gave it a second thought. True, this was the guy who told me to buy Amazon.com back in 1997, before it went on a 2,700% run.
Not to mention Amgen and Starbucks
Then the NASA scientist showed up. First, he used his big brain to randomly generate 25,000 hypothetical stock portfolios. Next, he created a portfolio of his own, using David Gardner's proprietary, so-called "alpha-generating" model. Turns out the NASA guy's portfolio outperformed 99.4% of the random portfolios.
Wait until you hear how he did it
Amazingly, that experiment isn't what changed my mind. Before I tell you what did make me a buyer, you must be wondering what David is feeding into his supercomputer to make it spit that alpha out. Oddly enough, it's you.
Gardner contends that many smart investors always know more than any one "expert." He's been proving this in an ad-hoc fashion for years. For example, he used this "community intelligence" to confirm his outlook on Disney
The experiment that changed everything
We discussed how David's NASA portfolio outperformed 99.4% of 25,000 random stock portfolios. But if you're like me, that sounds like a lot of fancy numbers. Here's a second experiment that convinced me that he and his scientist might really be on to something.
On Sept. 12, 2008, they applied their model to a handful of real-life portfolios -- namely, the stocks recommended in Motley Fool newsletter services. I like this approach for two reasons. First, these are real stocks, handpicked by real advisors in real time. Second, the guys who assembled these portfolios are good.
For example, when they ran the numbers back in September, David and Tom Gardner's Motley Fool Stock Advisor recommendations were up an average of 42%. That's darn good. Yet when David optimized the portfolio using just one factor from his model, he boosted those results by 17.6 percentage points -- and just as important, he did this with significantly fewer picks.
This is no fluke!
In fact, when taken across six different advisory services -- recommending stocks ranging from old-schools techs like Intel
All told, David's "community intelligence" filter cut the total number of picks nearly in half and increased the already solid returns by a stunning 19 percentage points per pick. So, that's how a NASA scientist would use your own intelligence to help you beat the market in theory.
Now, I'll tell you one way you can use alpha in your own portfolio, and then I'll show you how David Gardner proposes to do it on a grander scale.
If you own a mutual fund, try this. You can find a measure of your fund's alpha online (Morningstar's "Risk Measures" tab is a good place to start). Now, check out your manager's tenure. If you've got a high alpha (the higher, the better) with a five-year tenure, you've found the rare manager who actually adds value.
But back to the grand experiment. As you probably know, Gardner's been collecting intelligence data from more than 115,000 visitors to The Motley Fool website. Over the past few months, he assembled a team, including the NASA scientist I mentioned earlier, to help him analyze and back-test that data to consistently generate positive "alpha."
And he's done it!
Or so he claims. Gardner says he has finally tapped the collective intelligence of the world's smartest investors -- and more important, he can use this data to help you make money in your own portfolio. Here's how he plans to do it.
As we speak, Gardner, along with longtime Motley Fool analyst Jeff Fischer, is putting $1 million in real money to work in a long/short portfolio of stocks, options, and exchange-traded funds. The idea is to prove that they can combine their community-intelligence data and management skills to thump the market with that $1 million investment.
Why should you care? Well, here's the thing. On Jan. 12, David will invite a small number of Motley Fool readers to follow along with his unusual experiment in real time. In fact, he will even alert you to his trades in advance -- so that you can buy (or short) ahead of him. But be warned, the doors will be open for just 10 days.
If you're interested in options, shorts, and ETFs, or simply in learning more about this project, check out this message from David Gardner himself. It could be just the thing you need to beat this miserable market. To hear it straight from Gardner, and to receive a private invitation to learn more, simply enter your email address in the box below and click the button.
This article was first published Oct. 14, 2008. It has been updated.
Paul Elliott doesn't own any stocks mentioned in this column. Intel, Wal-Mart, and Starbucks are Inside Value recommendations. Amazon, Starbucks, Disney, and Game Stop are Stock Advisor picks. Vertex is Rule Breakers pick. JPMorgan Chase is an Income Investor pick. The Fool owns shares of Starbucks and shares and covered calls of Intel. The Motley Fool has a disclosure policy.