Investment and financial markets frequently use the terms “Chasing Alpha” and “Market Beta”. Although they may seem like complicated financial concepts, all investors should understand how Alpha and Beta function in the investment world. Alpha and Beta are often used as measures to evaluate the performance and risk of an investment portfolio or an individual security.
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The Alpha and Beta explained.
Alpha denotes the returns that exceed the initial investment return or benchmark. While Beta measures the correlation between a stock and the overall market. Beta helps in predicting the returns of an asset using the Capital Asset Pricing Model, while Alpha is the measurement of the absolute return exceeding that prediction.
Both these measures are easy to understand, despite appearing complicated. Beta clarifies the volatility of a security against the market. It helps investors determine if the stock moves in tandem or higher or lower than the market, reflecting the risk involved. Once an investor determines the cost of equity using the CAPM and decides that it is their desired return, anything that exceeds that is considered the alpha.
For instance, if a stock has a cost of equity of 10% and the investor manages to get a return of 12.5%, the Alpha is 2.5% as that is more than the required return. The same works for a benchmark and an investment portfolio.
Both alpha and beta are historical measures of past performances. A higher alpha is always good as it means the risk level is compensated accordingly. A high beta may be preferred by an investor in growth stocks but avoided by investors who seek steady and lower-risk returns with a Margin of Safety. The Alpha tells investors whether an asset has performed better or worse than the predicted beta.
What are the Alpha and Beta formulas?
The Alpha
Alpha is a measure of the return on an investment that is above the expected return based on the level of risk involved. It can be calculated for an individual security, an index fund, or an entire investment portfolio. To illustrate, suppose you are constructing a diversified portfolio with 25 positions, and the S&P 500 is your benchmark. If the S&P 500 returned 11% for the year and your portfolio returned 13%, then your alpha is 2%, as you have outperformed the benchmark by this percentage.
The Alpha is referred to as a measure of outperformance. This is how a higher alpha is linked to the level of risk, i.e., the beta. The formula will provide a number that translates to a percentage. For example, an Alpha of 2.0 means it outperformed a benchmark by 2%. If it is -10 it means it underperformed a benchmark by -10%.
- Asset Return = The actual return of the security or the portfolio after a set period depending on the investor’s measurement timeframe.
- Benchmark Return = The CAPM of the Security or the benchmark the fund is trying to measure against.
A more detailed breakdown of the formula is below:
Alpha = r – Rf – beta * (Rm – Rf )
- r = the security’s or portfolio’s return
- Rf = the risk-free rate of return
- beta =The security’s or portfolio’s price volatility relative to the overall market)
- Rm = the market return
The formula for calculating the return on investment is quite simple. Firstly, the investor needs to identify the individual security and the cost of equity, which is the expected return that the investor demands. This can be done using the Capital Asset Pricing Model. Once the Cost of Equity has been determined, it becomes the benchmark for the stock. Depending on the management style of the investor, alpha will be measured annually or when the security is sold, indicating whether the investment has underperformed or overperformed.
The Beta
Beta is a metric that measures a stock’s systematic risk, which is the investment risk related to the movement of the entire market. It has two types: Levered Beta and Unlevered Beta. The difference lies in the inclusion or exclusion of debt within the capital structure. Beta describes a security’s returns as it responds to swings in the market.
Measuring the average Beta of your portfolio can be a great way to manage volatility. This way, you can assess how your portfolio will swing concerning the overall market. Adding positions with a lower Beta to your portfolio can help counter volatility and risk.
Each stock moves based on its underlying business and news flow. Early-stage and small-cap stocks tend to have higher volatility, which results in a higher beta than stable companies. Liquidity and trading volume can also greatly affect Beta.
- Covariance = Changes in a stock’s returns in relation to changes in the market’s returns.
- Variance = How far the market’s data points spread out from their average value.
Covariance describes the correlation between an asset’s return and the market return. If both are moving in the tandem, the covariance is positive. However, if they move in the opposite direction, the covariance is negative. On the other hand, variance refers to the level of risk present in the overall market.
Beta is used as a key input in the Capital Asset Pricing Model to help work out the cost of equity of a company. The Beta helps investors weigh the return of a company against the risk associated with the broader market to ensure they are getting an adequate return for the risk.
Beta Chart outlining Correlation to Volatility
A correlation coefficient is a number that is used to describe the strength of a relationship between two variables.
| BETA | MARKET VS STOCK |
|---|---|
| > 1 | Higher Correlation + Higher Volatility |
| 1 | Higher Correlation + Same Volatility |
| 0 to 1 | Slight Correlation + Lower Volatility |
| 0 | No Correlation |
| -1 to 0 | Slight Inverse Correlation + Lower Volatility |
| -1 | High Inverse Correlation + Same Volatility |
| < -1 | High Inverse Correlation + High Volatilty |
As an example of how these relate to actual movements. Suggesting we have a beta of 1.2 this means the stock moves eithier 20% with the market when it goes up or 20% down when it goes down. If it is 1 it means it moves very similiar to the market.
What is Systematic and Unsystematic risk?
As an investor, you may come across two important terms – systematic risk and unsystematic risk. Systematic risk is related to external factors that are beyond your control, while unsystematic risk is related to internal factors specific to a particular company or industry. You cannot diversify away systematic risk, but unsystematic risk can be reduced or eliminated by diversifying your portfolio, holding long-term investments, and following a sound investment process.
Market risk is another term used interchangeably with systematic risk. It refers to the risk arising from broader market factors and is not based on individual securities. For instance, even if you have a diversified portfolio of high conviction stocks, a market crash can still affect it.
On the other hand, unsystematic risk can be mitigated to some extent by conducting due diligence, ensuring that the industries you invest in are not declining, and diversifying your portfolio. Holding quality companies for the long term can also help eliminate unsystematic risk while reducing systematic risk over longer holding periods. For example, beta can’t help to forecast what a stock will do if it faces industry challenges.
How can private investors use Alpha and Beta in Investing?
The concepts of Alpha and Beta are important in the financial markets, but many private investors do not subscribe to them. These metrics are intricately linked to what is taught in corporate financial courses that revolve around the Market Efficient Hypothesis and efficient frontier concepts. In brief, Alpha is considered difficult to generate as all available information is already factored into the pricing of securities.
Despite the fact that few investors achieve Alpha, economists believe that the possibility of coming up with an investment strategy that can beat the market is negligible and hardly probable. The accuracy of the Alpha concept is highly debated since security prices are dynamic and unpredictable by definition.
Rather than run through mathematical examples that may draw our attention more down the path of the corporate financial sector and away from the core of this blog. I will narrow down some examples of how investors can logically apply these terms to their investment journey.
Investors who need to use Beta can find it on multiple websites and need not run through covariance and variance formulas. Unless you are in the financial sector or conducting deep analysis I believe they are pointless to the majority of private investors. Time is money. I can get the beta on multiple websites such as Bloomberg, Yahoo Finance or S&P. I may use the Beta simply for the CAPM model and I never use it for modelling a portfolio.
The Alpha all I would suggest in addition to the formula is the ensure your benchmark is accurate. What I mean by this is if you benchmark against the S&P 500 or the ASX 200 for example, and you achieve a high alpha and you think you’re amazing, yet your portfolio is all in small-caps then it is inaccurate. The benchmark needs to be where your playground is. So the benchmark would be the Small-Caps index.
It’s all about the RISK.
If you’re a private investor and have a higher risk tolerance, investing in high-beta stocks may offer the possibility of higher gains. Both high and low-beta portfolios usually outperform the market. For instance, a diversified portfolio of growth stocks can perform well, while a conservative value approach with low beta can also be lucrative.
The ideas behind Alpha and Beta are directly related to the risk appetites of the investor or fund manager. If you want to be aggressive and target high-growth small caps, for example, the reward is high, but so is the risk. That is where the Beta comes into play with the cost of equity and then eventually the Weighted Average Cost of Capital in helping to determine the Discount Factor to ensure you are buying at the right entry price.
In Summary…
I do believe investors can and do generate Alpha. I have never subscribed to the concept of efficient markets all the time. This is because something driven by emotion and involving human beings tends to always create opportunities to find alpha. Creating an edge whether it is in analysis work, a thorough investment process, a long-term holding period and understanding your competence all go hand in hand when generating alpha.
Beta is another area while it can help in creating an idea behind the Cost of Equity and risk associated with a stock, it does little to help investors think logically. Investing is not about finding the perfect correlation between portfolio construction and complex modelling. All these numbers and financial terminologies draw so much focus away from the valuable information we need to know.
I have not provided in-depth examples in this blog post. Instead, I have focused on explaining the basic ideas behind Alpha and Beta. I believe that delving too deeply into these concepts can distract us from the goal of finding truly wonderful companies and holding them for the long term.
In my experience, all of my greatest investment successes have come from other forms of fundamental analysis, including my checklist, my thesis, and other forms of management. I rarely use Alpha or Beta in my holdings. However, I am always aware of the risks associated with any investment decision I make, as I value my capital greatly.
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