Rick Welch: Dollars and $ense
Investment Risk - Alpha and Beta
Understanding investment risk and how it impacts portfolio performance is essential for all investors. In general, there are five statistical measures of investment risk, all of which are historical predictors of the expected relationship between risk and volatility. They are alpha, beta, r-squared, standard deviation (covered previously in this column) and the Sharpe ratio. From this list, alpha and beta offer the investor two measures which are relatively easy to understand and apply to the security selection and asset allocation processes. Alpha and beta, when used together, can help investors assess the risk-reward parameters and overall suitability of their investments. To distinguish between these two terms, we suggest that you consider alpha as the goal and beta as the choice.
Alpha is often referred to as the difference between investment return and benchmark return. As defined, alpha “is a measure of investment performance on a risk-adjusted basis which is calculated by comparing the volatility (or price risk) of an investment to a benchmark index, like the S&P 500. The excess return (or difference) of the investment relative to the benchmark return is known as its alpha.” A positive alpha means that the investment has outperformed the benchmark index and that the investor has been adequately compensated for the risk taken. A negative alpha would indicate underperformance and suggest that the investor has not been fairly compensated for the risk assumed. The goal of any investor or portfolio manager is to strive then for positive alpha which is achieved through sound asset screening and selection, allocation, diversification and valuation strategies.
Beta, as defined, “is a measure of volatility, or systemic risk, of a security or a portfolio in comparison to the market as a whole. Beta is calculated using regression analysis and is often referred to as the tendency of an investment’s return to respond to swings in the market.” Systemic or market risk relates to changing conditions in the economy, such as monetary policy, inflation or the business cycle. Systemic risk, which is associated with all stocks, cannot be reduced through diversification. While there are a few exceptions (like some derivatives), beta values start at 0 and increase from there. The market (S&P 500) has a beta of 1.0 and individual securities have different beta values that depict how much their price movement deviates from that of the broader market. Low beta stocks, like utilities which often have betas of 0.3 to 0.6, pose less risk than the market but also have lower expected returns. Investors willing to accept higher volatility in order to capture higher returns may target more aggressive growth-oriented securities with betas over 1.0. The choice is up to you!
The concept of beta is a bit more straight-forward to understand and apply than that of alpha. Beta is a powerful tool that offers a clear and easily quantifiable method of assessing risk related to stock price variability. As a backwards-looking measure of risk, beta can however occasionally be a poor predictor of future stock price movement. One limiting factor of beta is that it does not distinguish between upside and downside price movement as even a low-beta stock will suffer price erosion when the broader market falls. Most investors find little solace in knowing that their portfolio (with its low beta stocks) suffered smaller losses than the index to which their investments are benchmarked.