Alpha and beta are the most imperative weapons in the arsenal of a trader in measuring risk, yet they are seldom discussed and inculcated in investment decisions by people who advise in investments and people who invest in investment products like mutual funds, shares, and ETFs.
But fret not! After reading this blog post, your perception of risk measurement will not remain the same!
So, instead of diving directly into the clichéd approach of using technical and complicated definitions, let us first try to understand the gist of alpha and beta through a simple analogy.
Let me introduce you to Mr. Thomas. He is a proud owner of a cricket franchise called the beta-kings. His team has been winning all the cricket matches on their home pitch. But here’s the catch! All his pitches are tailor made and suit his batsmen. Therefore, it’s not rocket science to believe that the perfectly tailored pitch is supporting the performance of his batsmen.
But completely un-prescient of the future, on a World Cup final match-day, green top completely alters the pre-tailored pitch, result being, the entire team fails except 1 player. And who is that player? The very famous Alpha de Niro. And why does he perform better than the rest? Because he has the experience of playing on all pitches – good or bad.
But you must be wondering by now as to how does it even remotely relate to alpha and beta? Aren’t these supposed to be some complicated mumbo jumbo terms involving some real math and stuff? Well to your utter amazement, they’re not!
The tailor-made a pitch here is beta, like the sea on which all ships sail. When the beta is favorable, it is like the rising tide that raises all the ships. But at times, when it is unfavorable like a storm ravaging the sea, it will tear apart and sink most ships. Only a few ships will weather the storm and survive. The ships that stand the test will have some unique quality, build, captain, some new tech etc. This unique property is its alpha. Similarly, Alpha de Niro in the above analogy has alpha!
Now that we have a basic essence of alpha and beta, let’s look at it more formally.
To understand the total risk in a portfolio what we need to measure is its market risk i.e. how sensitive our stock is to the market. This sensitivity is called beta (β).
Consider a stock X with a beta of 1.20. This means that when the market moves 1%, our stock moves 1.2%. Further, if the beta is 0.8, our stock will move 0.8% compared to 1% move in the market.
Thus stocks with betas greater than 1.0 tend to amplify the overall movements of the market. And stocks with betas in the range of 0 to 1.0 tend to move in the same direction as that of the stock, but not as far.
Alpha (α) on the other hand is the unique property of the investment that weathers out all the odds better than others and makes it outperform.
Consider the following 2 examples:
- Suppose NIFTY 50 rises by 10% and our portfolio return rises by 12%. This means we have outperformed the market by 2%. Further, if NIFTY 50 falls by 10% but out return falls only by 2%, this again implies that we have outperformed the market by 8%.
This measure of 2% or 8% is called alpha (α). This reflects our ability to beat the market. This is the holy grail of investing.
- To understand how alpha can play a significant role in the real marketplace, look at the following plot between the indexed closing prices of HDFC Bank and ICICI Bank.
When the market was facing turmoil due to the Indian Banking Crisis, on one hand, the prices of ICICI Bank were consistently falling while, on the other hand, the prices of HDFC Bank were stable and skyrocketed as soon as the market became favorable. Let’s analyze the situation in detail:
Following are the indexed prices and return generated by HDFC Bank, NIFTY and ICICI Bank in 2 scenarios – when the market was down and when the market was up.
*Prices are indexed relative to 100
As we can see, when the market (NIFTY in this case) was down by 18.61%, ICICI Bank was down by 49.48% whereas HDFC Bank was down by only 2.08%.
On the other hand, when the market was up by 21.92%, ICICI Bank was still down by 14.5% whereas HDFC was up by a whopping 98.89%.
Now, let’s use the Market Model to estimate alpha and beta of HDFC Bank and ICICI Bank. According to the Market Model,
Expected stock return = α + β(return on market index)
Extracting values from the table above, we get the following linear equations in 2 variables,
For ICICI Bank,
-49.48 = αICICI + βICICI (-18.61)
-14.45 = αICICI + βICICI (21.92)
For HDFC Bank,
-2.08 = αHDFC + βHDFC (-18.61)
98.89 = αHDFC + βHDFC (21.92)
After solving the above equations, we get the following values:
αICICI = -33.4
βICICI = 0.864
αHDFC = 46.54
βHDFC = 2.38
Thanks to the alpha it had (as we have calculated above), HDFC was able to generate extraordinary returns relative to ICICI Bank both when the market was up and when it was down.
In the subsequent blogs, we will try to find strategies to increase the alpha of our investment.
Until then, hasta-la-vista investors!