In this edition of The Most Misunderstood Investing Concepts I discuss the notion that α is creativity. In case you have missed other pieces in this series here are links to each of them:

• Fair value and its evil twin, target price;
• Time horizon and its subterranean influence on investors’ thinking;
• PEG ratios and the ignorance of the math underlying them;
• When valuing a business, growth is not free!; and,
• Risk does not equal volatility.

Creativity is Ignored

If I were to ask an audience of investment professionals to name the most important investment skills, I am guessing that most would choose things like analysis, rational or logical thinking, and so forth. This view of things likely stems from several sources. First, when considering terms like, ‘research analysis,’ or ‘financial analysis,’ we are primed by that word analysis. In turn, ‘analysis’ indicates analytical and that word is typically associated with rationality and logic. Great, I get it. But successful investing is so much more than just analysis. It is a wise blend of both analysis and innovative thinking, and it is creativity that is the source of differentiated and outstanding investment returns. But creativity is only rarely discussed in the world of investing. For example, it is not something specifically hired for by firms. Nor is it the subject of investment education and training. And the word itself almost never is a part of intrafirm discussions. In short, creativity is ignored.

A Crucial Analogy

An analogy makes clear just why ignoring creativity is one of the investment industry’s Achilles’ heels. Investing is like detective work. Imagine a crime scene, say a bank robbery, to which 10 detectives are asked to solve the crime. Yes, there is something to be said for the analytical firepower used to gather important facts. Things like, fingerprinting, security camera footage checks, witness interviews, a review of current or recent disgruntled employees, and so on.

While these things are certainly necessary, they are not sufficient to solve the crime. No, the detective that solves the crime is the one whose creativity allows her to identify which facts, from among possibly thousands, are the crucial facts. Not only that, but it is also the detective who can creatively piece the facts together into a meaningful narrative that explains the crime that is likely to solve it.

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This is just like in investing where almost every player is well schooled and beyond expert at the tools of the trade like financial statement analysis, and valuation. Likely they have access to and attempt to digest vast amounts of data. Even the sophisticated math and statistics used to try and find signal from among the noise of data is likely based on well-known statistics. They may even have artificial intelligence and machine learning enabled data gathering devices deployed using off-the-shelf solutions.

The point is that everyone is playing in this space, meaning that these efforts are β efforts, and not α efforts. Overwhelmingly, most of the value add is provided by creativity not technical advantage. Yet, the investing world misunderstands that alpha is creativity.

A Definition of Creativity

It may seem that creativity defies defining. Yet, creativity researchers in education, psychology, and neuroscience have spent over one hundred years gaining fluency in the subject. Most have converged on an understanding of creativity that is something like:

It is the ability to produce work that is novel (that is, original, unexpected), high in quality, and appropriate (that is, useful, meets task constraints).

Can you see just how similar this definition is to that of that most golden of investing outcomes, α? Here is the definition of α from Investopedia:

Alpha is used in finance as a measure of performance, indicating when a strategy, trader, or portfolio manager has managed to beat the market return over some period. Alpha, often considered the active return on an investment, gauges the performance of an investment against a market index or benchmark that is considered to represent the market’s movement as a whole.

Here is how they are analogous:

To me, alpha and creativity are equivalent terms. Thus, if you want to beat the market then, by definition, you must be creative. For greater details on creativity, including its necessary conditions see my series of co-authored with Focus Consulting Group’s founder, Jim Ware.

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