Greek language is often thought to be very
difficult, which is why we hear the expression,
“it’s all Greek to me” when
people do not understand something clearly. However, an interesting
known to some of us is that the Greek alphabet is the oldest alphabetic
in use today and its letters are widely used in mathematics and in
this article, we will be talking about two
of the more commonly used Greek alphabets in finance, particularly in
management – alpha and beta, which also happen to be the
first two letters of
the Greek alphabet. The symbol for alpha is α,
while the symbol
for beta is β.
it important to know what they are? In
short, yes. They are important especially if you have an investment
or if you are managing one actively for someone else. When we refer to
investment portfolio, it naturally assumes a certain amount of
meaning that the investor holds different types of asset classes, like
and equities, or simply a range of different types of equities in his
Simply put, a portfolio that is 100%
into one particular security cannot be considered to be diversified,
investing into just two securities already achieves a certain amount of
diversification. This is nothing new to most of us, because we
understand that diversifying reduces risk – if one investment
up in your face, at least you would still have the other portion of
in something else that is unlikely to melt down completely at exactly
time as the other investment.
to how diversified a portfolio should be,
that will be a topic for another article in the future. Yet it begs the
question: is it true that all risk can be diversified away?
is where beta comes in. (β).
Before we get to
that, we have to first understand that two types of risks exist for the
investor – systematic and unsystematic risk. It is important
to note that we
can easily reduce unsystematic risk through diversification.
the name implies, unsystematic risk is an
inherent risk in investing. Putting aside all these financial jargon
while, we can consider the analogy of a long-distance athlete (an
The athlete (investor) learns to train (invest) on the treadmill in the
every single day, and only on that one particular machine (an
portfolio). If the treadmill breaks down suddenly (investment makes
losses), his training will suffer badly as he does not know how to
anything else. The breakdown of the treadmill was an inherent risk when
the machine that the athlete could not have foreseen. This scenario is
the unsystematic risk that finance theory refers to!
if the athlete knows how to use the
rowing machine and/or the cycling machine, he would in effect have
diversification away from using just the treadmill machine, and reduced
unsystematic risk (or the equivalent of it in the athlete’s
that we understand unsystematic risk, the
concept of systematic risk should be clearer by now. Systematic risk
reduced, even if one is able to achieve perfect diversification. The
may know how to use every single machine in the gym, but that would not
him if the gym was suddenly closed for renovation or it suddenly burned
a freak accident.
that we have
gotten that out of the way, we can finally start talking Greek.
have established that investing always
involves certain amounts of risk, and that a certain type of risk known
systematic risk exists that cannot be reduced through diversification.
also called market risk, because even if you were to buy the entire
in the process achieving perfect diversification, systematic risk would
what does β measure?
the volatility of a security or a portfolio in relation to the market.
refer to the market, we usually refer to the returns of a particular
especially a broad-based one like the S&P 500. By definition,
the market has
an underlying beta of 1.0. The table below shows some examples of how
interpret various betas.
1: Interpreting Beta for Various
Assets / Portfolio
as volatile as the market.
as volatile as the market
of market volatility.
correlation with market movement. The security delivers positive
returns in a falling market and negative returns in a rising market.
will notice that in Table 1, beta is a
good measure of the risk (volatility) of a particular
relative to the market. In other words, it measures the effect of
risk on a particular security. A higher beta indicates that the asset
risky than the market and is thus expected to deliver higher returns
market as well.
is thus an extremely useful measure for
investors to understand how to create their own individual portfolios
accordance with their ability to take risk. Does this mean that one
their portfolios with securities that have higher betas than the
so that one can easily beat the market – supposedly the holy
grail of many
portfolio managers? We will look at
later when discussing alpha (α).
useful as beta is in giving us an
idea on risk, we should be aware that it does have its own limitations.
previously mentioned, beta measures risk of a particular security
the market – but no index exists where betas of all classes
of assets can be
measured against. Thus, we can only use a broad-based index like the
or the S&P 500 which are imperfect proxies for market risk.
beta is calculated based on
historical data. This means that it only gives us an idea of historical
the security relative to the market and cannot predict any change in
of the asset in the future.
beta is an extremely useful tool
for calculating the risk of holding a particular security within a
relative to the market risk and it is widely used in calculating
returns in financial models like the CAPM (Capital Asset Pricing
is good, more alpha is better. The
concept of alpha and the quest to produce it is all pervading within
investment world by active portfolio managers. What exactly is this
called alpha that makes it so sought after? To understand this better,
to understand some ideas about financial markets, particularly the
Market Hypothesis (EMH).
a nutshell, the EMH puts forth the
argument that financial markets are “efficient” in
the sense that all public
information on traded assets is already reflected in the price of the
other words, the collective expectation of the market about prices,
account all available information, makes it hard to generate abnormal
in the long run.
does not mean that good profits cannot
be generated in the short run, as markets may go through short windows
irrationality or new information may be filtered out into the market
inefficiently, allowing a small period by which privileged recipients
information may then be able to act on to generate profits. Yet most
of the EMH believe that it is extremely difficult to consistently beat
market in the long run, owing to this efficiency in the market.
it true that the market cannot be beaten
in the long run? Certain individuals have certainly done it like Warren
Buffett, known to many as an investment genius but also thought as a
statistical anomaly by many supporters of the EMH, as he has managed to
outperform the S&P 500 for over 40 years during his time as
Berkshire Hathaway, his investment holding company!
now readers should have an inkling of what
alpha is. Alpha really just refers to the additional returns over the
return. If you hear of a portfolio manager being able to
“generate alpha”, it
is tantamount to saying that he has delivered more returns than the
market – he
beat the market! In the world of active fund management, the ability to
generate alpha is extremely lauded by the industry, showing just how
this standard of performance has become in recent times.
article ties up a few simple financial
concepts along with the understanding of alpha and beta. How do alpha
relate to each other and how are we able to use them to judge the
of a portfolio manager?
can easily conclude for themselves
if a portfolio manager has performed well - bearing in mind that high
always come with higher risks. The most ideal scenario, assuming that
are risk-adverse, would be the one where investors are able to get the
possible returns for the lowest possible amount of risk.
high alpha (high excess returns) in
isolation may not be looked upon as favorably if the beta (risk
relative to the
market) of his portfolio was extremely high. As proponents of investor
education, we hope that introducing these concepts will allow investors
understand the concepts of alpha and beta, and if possible, pave the
making better investment decisions going forward. Hopefully, you have
good time learning Greek!