Tag: funds

  • What Is Alpha In Investing – How to Beat the Market

    What Is Alpha In Investing – How to Beat the Market

    What Is Alpha In Investing
    Alpha represents a measure of an asset’s return on investment compared to the risk-adjusted expected return.
    Beta represents a measure of volatility. Beta measures how an asset moves versus a benchmark.

    What is Alpha? Alpha is a measure of the performance of an investment in comparison to a fitting market index, for example, the S&P 500. The base value is zero. And when you see the number one in Alpha that means that the return on the investment outperformed the overall market average by 1%. A negative alpha number shows that the return on the investment is underperforming in comparison to the market average. This measure is applicable over a strictly defined time frame.

    What is Alpha more? It is one of the performance ratios that investors use to evaluate both individual stocks and portfolio as a whole. Alpha is shown as a single number, for example, 1, 2, 5 but expressed as a percentage. It shows us how an investment performed related to a benchmark index. For example, a positive alpha of 4 (+4) suggests that the portfolio’s return outperformed the benchmark index’s performance by 4%.  But the alpha of negative 4 (-4) means that the portfolio underperformed the index by 4%. When alpha is zero that means that your investment had a return that met the overall market return.

    What is Alpha of a portfolio?

    It is the excess return the portfolio yields related to the index. When you are investing in some ETF or mutual funds you should look if they have high alpha because you will have better ROI (Return on Investment).

    But you cannot use this ratio solely, you have to use it together with a beta. Beta is a measure of investment volatility. The beta will show you how volatile one investment is compared to the volatility of, for example, the S&P 500 index.

    These two ratios are used to analyze a portfolio of investments and assess their theoretical performance.

    How to calculate?

    First, you have to calculate the expected rate of return of your portfolio. But you have to do that based on the risk-free rate of return, market risk premium, and a beta of the portfolio. The final step is to deduct this result from the actual rate of return of your portfolio.

    Here is the formula

    Expected rate of return = Risk-free rate of return – β x (Market return – Risk-free rate of return)

     and

    Alpha of the portfolio = Actual rate of return of the portfolio – Expected Rate of Return on Portfolio

    The risk-free rate can be discovered from the average annual return of security, over a longer period of time.

    You will find the market return by tracking the average annual return of a benchmark index, for example, S&P500. The market risk premium is calculated by deducting the risk-free rate of return from the market return.

    Market risk premium = Market return – Risk rate of return

    The next step is to find a beta of a portfolio. It is determined by estimating the movement of the portfolio in comparison to the benchmark index. 

    So, now when we have this result, expected rate of return, we can calculate further. We have to find the actual rate of return. It is calculated based on its current value and the prior value.

    And here we are, we have the formula for calculation of alpha of the portfolio. All we have to do is to deduct the expected rate of return of the portfolio from the actual rate of return of the portfolio.

    That was a step by step guide for this calculation.

    Becoming an Alpha investor

    There is a great discussion about should the average investor look for alpha results of a portfolio. But we can hear that investors mention alpha. This is nothing more than the amount by which they have beaten or underperformed the benchmark index. It can be the S&P 500 index if you are investing in the US stock market. In such a case, that would be your benchmark.

    For example, if the benchmark index is up 4% over the period, and your portfolio is up 6%, your alpha is +2. But if your portfolio is up 2%, your alpha is -2.

    Of course, everyone would like to beat the benchmark index all the time. 

    What is the Alpha investing strategy?

    We know that Alpha is a measure of returns after the risk is estimated. Risk is determined as beta, a measure of how volatile one investment is related to the volatility of the benchmark index.

    Alpha strategies cover equity funds with stock selection. Also, hedge fund strategies are a popular addition in alpha portfolios.

    Something called “pure alpha” covers hedge funds and risk premia strategies. The point is that by adding an alpha strategy to your overall portfolio you can boost returns of the other investment strategies that are not in correlation.

    Alpha is the active return on investment, measures the performance of an investment against a market index. The investment alpha is the excess return of investment relative to the return of an index.

    You can generate alpha if you diversify your portfolio in a way to eliminate disorganized risks. By adding and subtracting you are managing the risk and the risk becomes organized not spontaneously. When alpha is zero that means the portfolio is in line with an index. That indicates that you didn’t add or lose any value in your portfolio.

    When an investor wants to pick a potential investment, she or he considers beta. But also the fund manager’s capacity to generate alpha. For example, a fund has a beta of 1 which means it is volatile as much as the S&P index. To generate alpha, a fund manager has to generate a return greater than the S&P 500 index.

    For example, a fund returns 12% per year. That fund has a beta of 1. If we know that the S&P 500 index returns 10%, it is said the fund manager generated alpha returns.

    If we consider the risks, we’ll see the fund and the S&P index have the same risk. So, the fund manager generated better returns, so such managers generated alpha. 

    Alpha in use

    You can use alpha to outperform the market by taking more risks but after the risk is considered. Well, you know that risk and reward are in tight relation. If you take more risks, the potential reward will go up. Hence, limited risks, limited rewards.

    For example, hedge funds use the concept of alpha. They use beta too, but we will write later about the beta. The nature of hedge funds is to seek to generate returns despite what the market does. Some hedge funds can be hedged completely by investing 50% in long positions and 50% in short positions. The managers will increase the value of long positions and decrease the value of their short positions to generate positive returns. But such a manager should be a ninja to provide gains not from high risk but from smart investment selection. If you find a manager that can give you at least a 4% annual return without a correlation to the market, you can even borrow the money and invest. But it is so rare.

    Alpha Described

    What is alpha more? It is often called the Jensen index. It is related to the capital asset pricing model which is used to estimate the required return of an investment. Also, it is used to estimate realized achievement for a diversified portfolio. Alpha serves to discover how much the achieved return of the portfolio differs from the required return.

    Alpha will show you how good the performance of your investment is in comparison to return that has to be earned for the risk you took. To put this simply, was your performance adequate to the risk you took to get a return.

    A positive alpha means that you performed better than was expected based on the risk. A negative alpha indicates that you performed worse than the required return of the portfolio. 

    The Jensen index allows comparing your performances as a portfolio manager or relative to the market itself. When using alpha, it’s important to compare funds inside the same asset class. Comparing funds from one asset class, otherwise, it is meaningless. How can you compare frogs and apples?

    What is beta?

    When stock fluctuates more than the market has a beta greater than 1.0. If stock runs less than the market, the beta is less than 1.0. High-beta stocks are riskier but give higher potential returns. Vice versa, stocks with lower beta carries less risk but yield lower returns.

    Beta is usually used as a risk-reward measure. It helps you determine how much risk you are willing to take to reach the return for taking on that risk. 

    To calculate the beta of security, you have to know the covariance between the return of the security and the return of the market. Also, you will need to know the variance of the market returns. The formula to calculate beta is

    Beta = Covariance/Variance

    ​Covariance shows how two stocks move together. If it is positive that means the stocks are moving together in both cases, when their prices go up or down. But if it is negative, that means the stocks move opposite to each other. You would use it to measure the similarity in price moves of two different stocks.

    Variance indicates how far a stock moves relative to its average. You would use variance to measure the volatility of stock’s price over time.  

    The formula for calculating beta is as shown above.

    Beta is very useful and simple to describe quantitative measure since it uses regression analysis to gauge the volatility. There are many ways in which beta can be read. For example, the stock has a beta of 1.8 which means that for every 1% correction in the market return there will be a 1.8% shift in return of that stock. But we also can say that this stock is 80% riskier than the market as a whole. 

    Limitations of Alpha

    Alpha has limitations that investors should count when using it. One is related to different types of funds. If you try to use this ratio to analyze portfolios that invest in different asset classes, it can produce incorrect results. The different essence of the various funds will change the results of the measure. Alpha is the most suitable if you use it strictly for stock market investments. Also,  you can use it as a fund matching tool or evaluating comparable funds. For example, two large-cap growth funds. You cannot compare a mid-cap value fund with a large-cap growth fund.

    The other important point is to choose a benchmark index. 

    Since the alpha is calculated and compared to a benchmark that is thought suitable for the portfolio, you should choose a proper benchmark. The most used is the S&P 500 stock index. But, you might need some other if you have an investment portfolio of sector funds, for example. if you want to evaluate a portfolio of stocks invested in the tech sector, a more relevant index benchmark would be the Dow technology index. But what if there is no relevant benchmark index? Well, if you are an analyst you have to use algorithms to mimic an index for this purpose.

    Limitations of beta

    The beta is good only for frequently traded stocks. Beta shows the volatility of an asset compared to the market. But it doesn’t have to be a rule.  Some assets can be risky in nature without correlation with market returns. You see, beta can be zero. You should be cautious when using a beta.

    Also, beta cannot give you a full view of the company’s risk outlook. For short-term volatility it is helpful but when it comes to estimating long-term volatility it isn’t.

    Bottom line

    What is alpha? It began with the intro of weighted index funds. Primarily, investors started to demand portfolio managers to produce returns that beat returns by investing in a passive index fund. Alpha is designed as a metric to compare active investments with index investing. 

    What is the difference between alpha and beta?

    You can use both ratios to compare and predict returns. Alpha and beta both use benchmark indexes to compare toward distinct securities or portfolios.

    Alpha is risk-adjusted. It is a measure that shows how funds perform compared to the overall market average return. The loss or profit produced relative to the benchmark describes the alpha. 

    On the other hand, beta measures the relative volatility of assets compared to the average volatility of the entire market. Volatility is an important part of the risk. The baseline figure for beta is 1. A security with a beta of 1 means that it performs almost the same level of volatility as the related index. If the beta is under 1, the stock price is less volatile than the market average. And vice versa, if the beta is over 1, the stock price is more volatile. There is some tricky part with beta value. If it is negative, it doesn’t necessarily mean less volatility. 

    A negative beta means that the stock tends to move inversely to the direction of the overall market.

  • Diversification Is Important to Your Investment Portfolio

    Diversification Is Important to Your Investment Portfolio

    Diversification Is Important to Your Investment Portfolio
    When stock prices drop, bond prices increase. A portfolio that holds stocks and bonds plays better than the one that holds only stocks.

    Diversification means to spread the risk across different types of investments. The main purpose of diversification is to enhance your chances of investment success. In other words, you are betting on every one.

    Diversification is very important in investing because markets can be volatile and extremely unpredictable. If you diversify your portfolio, you will reduce the chance to lose more than you are prepared to.

    And that is exactly what you would like in investing: to spread your capital among different assets. So you’re not relying on a single asset for all of your returns. The key advantage of diversification is that it provides you to minimize the risk of losing the capital invested.

    What is diversification?

    Diversification means building a portfolio of your investments in a way that the majority of the assets will have a different reaction to the same market performance. For example, when the economy is growing, stocks will outperform bonds. In opposite circumstances, bonds could play better than stocks. Hence, if you hold both stocks and bonds, you will reduce the risks in your portfolio from market swings. 

    Let’s make this more clear. What do you have in your pantry? Only beans? Of course not! When you went to the grocery you bought everything you need for the week or month ahead. The same should be with your investment portfolio. It should consist of various assets. But not too many. Too many assets mean you will not be able to follow their performances. If you are fresh in the stock market, maybe a two-fund portfolio is a good choice for you. More about this you can read HERE

    Think of these various types of groceries as the different areas, techniques, and areas available to you as an investor. If you have a variety of assets, you’ll be better protected. In the situation when one of your assets is hit by the risk you will still have the others that can give you a profit.

    Reasons for diversification

    Even the explanation is so simple you can still find so many investors that play on one card. You may ask how some really smart guys could avoid diversification and put all eggs in one basket? We couldn’t find the proper answer because the benefits are so obvious.

    By diversification, investors lower the overall risk. It is logical how this works. When you spread your investments in various classes (diversifying them) you have more chances to avoid the negative influence in your portfolio. For example, let’s say you invested in stocks only and you hold a stock of just one company. Yes, we know you like it, it is a good company, famous, well-run. But if suddenly something unpleasant hit it and the stock price drops, let’s say, for 30%, how that occasion will influence your overall portfolio? You will lose 30% of your portfolio.  But let’s consider the other situation. Let’s say that stock makes up a modest part of 5% in your portfolio. So, how much of your overall portfolio you will lose now? Can you see where is the benefit of diversification? It lowers the risk. Even during economic downturns, you will still have good players in your portfolio. Hence, if you have bonds and stocks added to your portfolio, it is more likely that even one of them will run well during particular circumstances. Bonds will play better when the economy is decreasing, but when the economy is growing, stocks will outperform bonds.

    Diversification and investment strategy

    You can find various investment strategies but two are most popular: growth and value investing.

    Value investors tend to consider the strength of a company and its management. They would estimate if the company’s stock price is undervalued based on its true worth. 

    On the other side, growth investors would estimate how fast the company is growing, could its new products stimulate future earnings, etc.
    By taking just one strategy you can miss out on the benefits of the other. But if you spread your investments on both of these strategies, it is pretty sure that you’ll be able to enjoy the benefits of each.

    Influence of “home country bias”

    Well, it is completely natural that investors are more attracted to their own state markets, the national industry. That’s how we come to the “home country bias”  in investing. Of course, it is a natural tendency. But it can be a problem too. “Home country bias” can limit your investments to the offer from domestic markets. But what is needed for profitable and successful investing is to step out of your comfort zone. Foreign markets can be profitable also. What you have to do as an investor is to add some international fund or company to your portfolio. It is good protection and well-done diversification. Diversification across international markets will protect your investments if the domestic economy downturns (no one wants that, of course) or during the recession in your country. Several years ago we heard one of the investors saying it isn’t a patriotic gesture. Well, we have to say, investing isn’t an act of patriotism. It is all about profit.

    Produces more opportunities

    Eventually, diversification produces more opportunities if you make smart choices that deliver balance to your investment portfolio. 

    For example, you only invest in stocks. But suddenly some great opportunity occurs to invest in, for example, bonds. What will you do? Refuse to invest in bonds because you are not comfortable with them and risk to miss potential profit? We don’t think it is a smart idea. Never miss the opportunity to earn more, that isn’t in the nature of investing. Admit, you will never miss this opportunity to invest in bonds if you have a diversified portfolio. So, diversification gives you more opportunities to invest.

    Protect and improve your finances

    It is important to understand all the benefits of diversification. It isn’t hard to do. Actually, it is very simple. You have to read more, learn and be patient. If you diversify your investment portfolio you will have a chance to build stable finances over time.

    How to diversify your portfolio

    Firstly, never be too much invested. You will not be the winner if you own hundreds of assets. Okay, let’s say this way. Your portfolio is your team. And, as in every team, each part plays its role. No coach will put all players in one position. It’s stupid. Plus, how such a team will win anything? Of course, zero chances! 

    The point of diversifying is to hold investments that able to work separated tasks on your team. 

    Every single part of your portfolio should have a different role. For example, if you prefer stocks, diversify your portfolio to S&P 500 (that would provide you exposure to large-caps) and add some small-caps.

    If you have a bond portfolio diversify it across short and long bonds, or higher-quality bonds, etc. That will reduce the risks. Or just add alternative investments in your portfolio. For example, private equity, hedge funds, real property, venture capital, commodities, etc.

    Bottom line

    How will you know you’re diversified? A well-diversified investment portfolio will never move in the same trend and at the same time. You must have one thing on your mind: you are the manager of your portfolio. Also, it is almost impossible for all investments to grow all the time. It is 100% sure that some of your positions will be lost, will lose you money. When that happens you will need the other holdings to balance that fall.

    Diversification guards you against producing an undesired risk to your capital. Anyway, it is too risky to put all your money into one single investment. The key to diversification is to spread your money across asset classes and to allocate within classes. That is a smart approach.