Stock market investment: Alpha, Beta and stuff
Alpha is a risk-adjusted measure of the so-called active return on an investment. It is the return in excess of the compensation for the risk borne, and thus commonly used to assess active managers’ performances. Often, the return of a benchmark is subtracted in order to consider relative performance, which yields Jensen’s alpha.
The alpha coefficient (αi) is a parameter in the capital asset pricing model (CAPM). It is the intercept of the Security Characteristic Line (SCL). Alternatively, it is also the coefficient of the constant in a market model regression.
It can be shown that in an efficient market, the expected value of the alpha coefficient is zero. Therefore the alpha coefficient indicates how an investment has performed after accounting for the risk it involved:
- αi < 0: the investment has earned too little for its risk (or, was too risky for the return)
- αi = 0: the investment has earned a return adequate for the risk taken
- αi > 0: the investment has a return in excess of the reward for the assumed risk
For instance, although a return of 20% may appear good, the investment can still have a negative alpha if it’s involved in an excessively risky position.
Besides an investment manager simply making more money than a passive strategy, there is another issue: Although the strategy of investing in every stock appeared to perform better than 75 percent of investment managers, the price of the stock market as a whole fluctuates up and down, and could be on a downward decline for many years before returning to its previous price.
The passive strategy appeared to generate the market-beating return over periods of 10 years or more. This strategy may be risky for those who feel they might need to withdraw their money before a 10-year holding period, for example. Thus investment managers who employ a strategy which is less likely to lose money in a particular year are often chosen by those investors who feel that they might need to withdraw their money sooner.
The measure of the correlated volatility of an investment (or an investment manager’s track record) relative to the entire market is called beta. Note the “correlated” modifier: an investment can be twice as volatile as the total market, but if its correlation with the market is only 0.5, its beta to the market will be 1.
Investors can use both alpha and beta to judge a manager’s performance. If the manager has had a high alpha, but also a high beta, investors might not find that acceptable, because of the chance they might have to withdraw their money when the investment is doing poorly.
These concepts not only apply to investment managers, but to any kind of investment.
A coefficient measuring a stock’s relative volatility to a market index, such as the S&P 500 Index. A manager with a Beta greater than 1.0 is more volatile than the market, while a manager with a Beta less than 1.0 is less volatile than the market.
“An important measure of a stock’s (or a portfolio’s) volatility in relation to the Standard & Poor’s 500, which by definition has a beta of 1.0. A beta higher than this implies greater volatility than the overall market. Thus, a stock with a beta of 1.5 will move up 15 percent when the market rises 10 percent. In good times, high betas imply high returns, since a beta above 1.0 amplifies the market’s movements. In bad times, of course, a beta below 1.0 is desirable, since you wouldn’t want your portfolio to magnify downward movements. Ideally, you want a low beta and high returns, which is hard to get. You can lower the overall beta of your portfolio by adding lower beta stocks to the mix, in effect diversifying away some of the volatility.”
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