E Greek To Me?

"It's all Greek to me", commented subscriber PM about my note yesterday. So for those not familiar with current stock market jargon, here are some definitions of alpha and beta. Technically speaking, they are both ratios used as statistical measurements for calculating returns and risk against a benchmark. They are part of the Capital Asset Pricing Model, or CAPM, for which several economists have been given not-quite Nobel Prizes. (There is no Nobel Prize for economics but one was added and it pays in money and prestige as well as the older prizes.)

Both alpha and beta are meant to help investors determine the risk-versus-reward profile of an investment portfolio, usually used for mutual and exchange traded funds. But the Greek letters can also be used for individual stocks against a benchmark index.

Alpha is determined using a mathematical formula estimating the market return of the investment compared to that of the benchmark. Alpha is an investment's or fund's excess return found by comparing its risk-adjusted over- or under-performance against how its benchmark index did. Excess return of a fund or share relative to the index under the capital asset pricing model is its positive alpha or out-performance. If it failed to do as well as the index, it has negative alpha, and under-performed.

For both alpha and beta, the formula to work out the percentage is: Return = (EP +D - SP) /SP or in English, the total of End Price plus Distribution per share minus Start Price, all divided by Start Price. The duration, the period over which you work out alpha is up to you. But you need to use the same period for both your holding and the index you are comparing it to. You calculate the index return using the same formula.

Usually alpha is calculated annually against a well-known index like the S&P 500, MSCI, the FTSE, etc. One of the problems with this is volatility, defined to mean by movement of the values of funds holdings or that single stock in either direction vs its benchmark during shorter periods than the annual alpha tally simply because your holding is not tracking the index well. The idea is to separate volatility and fluctuations caused by not matching that benchmark from those producing performance. Without beta, alpha merely measures how well your fund or stock is tracking its benchmark index, not how much risk it is taking to try to beat it.

So meet beta, which compares a fund or stock's volatility, its moves up and down in trading, compared to the moves of that benchmark.

Beta uses the very same formula (this is not higher mathematics) but it works out the variation of return versus the benchmark over a much shorter time-frames, like a week, a month or a quarter. It is looking for lots of data on how much the return of your holding varied from the benchmark This is defined as volatility, which is then called risk. Volatility goes up if your holding frequently failed to closely match the benchmark in either direction, up or down.

A positive alpha of 1.0 means the fund or stock has outperformed its benchmark index by 1%. A negative alpha of 1.0 indicate an under-performance of 1%.

A beta of less than 1 means that the security is less volatile than the market. A beta greater than 1, it means its price is more volatile than the market. So for example, if the stock has a beta of 1.2, it is 20% more volatile. If it moves less than the market, with a beta of 0.8, it is less volatile. For all intents and purposes, volatility is treated as the equivalent of risk, which has to be deducted to work out performance or alpha.

Now a shocker: most funds have negative alpha, mainly because of management costs and as they try to create a proxy for the big indexes they track without buying every Little Dingbat Company in it.

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Disclosure: None. 

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