At LENSELL, we strive to make financial literacy accessible to everyone so that you can make informed investment decisions and grow financially. In our last blog, Diversification 101, we discussed the importance of Portfolio Diversification. This time, we will explore two indicators that will help you understand portfolio performance and see how they can assist in making better informed investment decisions.
Financial markets are always prone to financial risks and there are several factors contributing to it - macroeconomic forces, unprecedented events, disasters, market interest rate, or the possibility of default by sectors or large corporations (Investopedia,2021). Sometimes risks are simply those inherent to business operations in a dynamic economic environment. Basic understanding of these financial risks can help you strategically invest in assets that may generate the expected returns.
To start off, let's look at two concepts: Alpha and Beta - and see what they tell. Alpha and Beta are the key measurements that help you assess and estimate the performance of an investment or portfolio compared with the entire market.
What is Alpha?
Alpha, also known as the Jensen index, is one of the several standard ratios that are used to evaluate individual stocks or investment portfolios (Corporate Finance Institute, 2021). It measures the performance of a stock or investment portfolio against a certain benchmark- usually the entire market, using what is known as a 'stock market index. By this, Alpha gives one an insight into the degree to which an investor can 'beat' the market in terms of returns (IG,2021).
Alpha-focused investing means to make adjustments to the overall portfolio to achieve a positive alpha, which in turn positively impacts diversification (M1Finance, 2021).
The Portfolio Alpha indicator helps one understand the expected return of your portfolio in comparison to the expected return of the entire market. A positive Portfolio Alpha indicates that your portfolio is expected to earn more than the entire market, while a negative Alpha indicates that your portfolio is expected to earn less than the entire market. For example, Alpha = 0.2% indicates that the investment or portfolio is expected to earn 0.2% more than the return of the market. Higher the alpha, the higher the expected return from your portfolio over the return of the entire market.
How is Alpha calculated? Alpha is calculated using a few important financial indicators: the realised return of the portfolio or investment, the realised return of the market index, the risk-free rate of return for the time period and the systematic risk of the investment or portfolio (represented by Beta, see the section below). For more details on the calculations and formula you can check WallStreetMojo,2021.
What is Beta?
Beta is a measurement of the volatility of the investment or portfolio returns relative to the volatility of the entire market. It is used as a measure of systemic risk, and it is a critical component of CAPM (Capital Asset Pricing Model) (Corporate Finance Institute, 2021).
A beta greater than one indicates that your investment or portfolio is expected to be more volatile than the entire market, while a beta lower than one indicates that your investment or portfolio is expected to be less volatile than the market. Lower the Beta, less volatile the investment or portfolio compared with the entire market.
Beta is a measure of systematic risk. The systematic risk is a risk that all assets in a marketplace (or even across multiple marketplaces) share - for example, the wide stock markets fall due to the Great Financial Crisis in 2008-2009 or due to the Covid-19 pandemic in 2020. When systematic events happen, the entire stock market is in a declining phase, and no amount of diversification can save investors from losing out on their money (Investopedia,2021). Unsystematic risks, on the other hand, are risks due to normal business operations and economic environment, and they can be lowered through diversification - that is, through selecting investments that are known to behave differently in the same market context.
Investors need to have a good understanding of their own financial risk tolerance levels and match them with the expected investment or portfolio risk. When there is a disconnect between the two, investors live with a permanent worry about the risk of their investments.
How is Beta calculated? - Beta for an investment or portfolio is obtained by dividing the covariance of the investment returns and market returns to the variance of the market returns for a given period of time. For more details on the calculations and formula, you can check: Investopedia, 2021.
Why are Alpha and Beta so important?
Investors should use Alpha and Beta to understand how an individual stock or a portfolio is performing. An investor with a high appetite for risk may look for a high Alpha while accepting a high Beta (Quantilia, 2021). The opposite is true as well, and many investors with a low appetite for risk go for a low Beta while accepting that their portfolio may not even reach the market returns (i.e. a negative Alpha).
As discussed, it is important for an investor to fully aware of the expected performance of the investments they make. While black swan events (unique and unprecedented events that could cause global damage economically) cannot be avoided, investors can plan for them by making use of the performance indicators to get a glimpse into how their portfolios are expected to behave compared with the overall market.
Where can you find Alpha and Beta?
Several investment platforms give Beta for individual investments, however, none gives you Beta or Alpha for a tailored portfolio.
At LENSELL, we help investors make better informed decisions. Diversiview® is The #1 Portfolio Planning Tool that lets users design tailored, risk-informed diversified portfolios. As part of Diversiview® analyses, users get access to numerous performance indicators, including Alpha and Beta!
Make sure you check it out today and see what they tell about your portfolio.
- Team LENSELL