If what I'm about to tell you sounds too good to be true, I don't blame you. I was a skeptic, too.
And I've been at this a while. Including five years holed up with a "quant" whacko 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.
This much I know for sure: Alpha is the driving force behind a trillion-dollar hedge fund industry. Kind of remarkable, given that I remember paying nearly that much for some wise guy to teach me that alpha doesn't even exist!
And for years, that's what I believed. Sure, I'd seen investors beat the market. But I'd also seen them get crushed. 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 and colleague 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 (NASDAQ:AMZN) back in 1997, before it went on a 2,700% run.
Not to mention Amgen (NASDAQ:AMGN) in 1998 and AOL in 1994 at $0.43 a share -- long before the Time Warner (NYSE:TWX) debacle. The guy has a nice touch, but that's a far cry from generating true, positive alpha. And remember, all I really cared about in terms of alpha was that I barely believed it existed.
That's when the NASA scientist started playing hardball. 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 "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. Seriously.
You see, David has long argued that many smart, ordinary investors will always be smarter than any one "expert." He's been proving this theory in an ad-hoc fashion for years -- using what he calls "community intelligence" to confirm his outlook on game developer Activision Blizzard (NASDAQ:ATVI), for example.
The stock has risen some 460% since he recommended it in 2003. It was a similar story in 2001 with eBay (NASDAQ:EBAY), and in 2005 with Intuitive Surgical (NASDAQ:ISRG), which has climbed by 110%.
According to Gardner, he's now found a way to collect his community intelligence on a mass scale and "quantify" it. In other words, he's transformed a disparate bunch of opinions, insights, and bits of knowledge from something he could vaguely process in his own head into something a guy from NASA could stuff into a model.
The experiment that changed everything
We discussed how Gardner'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.
This time, they applied their model to a handful of real-life portfolios -- namely, the stocks recommended in Motley Fool premium 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.
Across six different investment advisory services -- recommending stocks as diverse as Microsoft and Bank of America (NYSE:BAC) -- the results were striking. Gardner's "community intelligence" filter cut the number of picks nearly in half and increased the already blockbuster returns by a stunning 19 percentage points per pick.
Fewer picks, higher returns
So if you ever wondered how a NASA scientist would use your own intelligence to help you beat the market in theory, there you have it. 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.
In you own a mutual fund, give this try. Cross-reference your fund's alpha with its managerial tenure. (Morningstar's "Risk Measures" tab is a good start.) If you find a high alpha (the higher, the better) and your manager's been at it five years or more, you may have found one of the few gems in the fund-manager world.
As you probably know, David 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 assures me. Gardner insists he has finally tapped the collective intelligence of the world's smartest investors -- and more importantly, he can use this data to help you make money in your own portfolio. Here's how he plans to do it.
Along with longtime Motley Fool analyst Jeff Fischer, Gardner is investing $1 million of his company's real money in a long/short portfolio of stocks, options, and exchange-traded funds. They aim to prove that they can combine their community-intelligence data and portfolio-management skills to thump the market with that $1 million investment.
Why should you care? Well, here's the thing. For 48 hours starting midnight March 24, Gardner will invite a small number of Motley Fool readers to follow along with this experiment in real time. In fact, he will announce his trades in advance -- so that you can buy (or short) ahead of him.
If you're interested in learning more, simply click here. It could be just the thing you need to get you through this miserable market -- and out the other side with more money than you have right now. To receive a private invitation and to learn more, simply enter your email address in the box below.
This article was originally published Dec. 24, 2008. It has been updated.
Paul Elliott owns shares of Bank of America. Microsoft and eBay are Motley Fool Inside Value selections. eBay, Activision Blizzard, and Amazon are Stock Advisor picks. Intuitive Surgical is Rule Breakers pick. The Motley Fool has a disclosure policy.
