Knowing These Greek Letters Can Profit You
Wall Street is full of jargon. Long, short, buy side, sell side, short interest, short squeeze, etc. The list goes on and on.
Some of those terms are intuitive. You don’t need to have years of investing experience to know what they mean. You may even be able to accurately guess what they mean the first time you hear the term.
Today I will discuss two common terms used by investing professionals: alpha and beta. Unlike other Wall Street jargon, the terms themselves are just Greek letters and don’t give a clue as to what they mean.
The CAPM Model
Before we get into alpha and beta, it helps to first understand a stock (asset) pricing model called the capital asset pricing model (CAPM). The formula is below.
The left side of the equation is the expected return of the stock. It’s equal to the risk-free interest rate plus the expected return of the market minus the risk-free rate multiplied by the beta of the asset.
The risk-free rate is typically considered to be the interest rate on the 10-year Treasury Note.
The expected return of the market is the return of a market index. For stocks, often the expected return of the S&P 500 is used in the formula.
The difference between the expected return of the market and the risk-free rate (the part in the parenthesis) is called the “market risk premium.” Essentially, it means your expected return for taking on risk and investing in the stock market instead of investing in a risk-free asset.
The final term in the formula is the aforementioned beta.
So What Is Beta?
Beta is a measure of volatility of the stock relative to the overall stock market. It is calculated using the variance of the market’s returns and the covariance of the stock’s returns with the market’s returns. You don’t have to worry about how to calculate the beta; you should just know what it means.
If a stock has a beta of 1, this means that it tracks the market perfectly. If a stock has a beta of -1, it means that the stock moves in the exact opposite of the market. So if the S&P 500 gains 5%, you would expect the stock with a -1 beta to go down 5%. If a stock had a beta of 0, then it’s not correlated with the market, and you would expect the return to be close to the risk-free rate.
See for yourself in the formula above, if the beta is 0, then the systematic risk premium becomes 0 as well. (Zero multiplied by anything equals zero.)
Knowing Beta Helps Manage Risk
To be clear, beta is only an estimate of how a stock may move. In real life, especially over short periods, a stock can behave quite differently than what its beta may predict.
However, imperfect as an estimate may be, a stock’s beta is still useful to know because it can help you manage the risk in your portfolio.
The key point is that a high-beta stock is one that will likely outperform the market when the market goes up, and underperform when the market goes down. If you are an aggressive investor, you may want to hold more high-beta stocks. But if you are a conservative investor, you may want to have more low-beta stocks. Note: low beta would be something like 0.5. It does not mean negative beta.
What About Alpha?
In the CAPM formula, there’s no mention of alpha. But alpha is related to the formula.
Keep in mind that the CAPM formula gives you the expected return of the stock. Chances are, the stock’s actual return will be different. This difference is the stock’s alpha.
Let’s use an example. Let’s say that stock XYZ has a beta of 1.2, the risk-free rate is 2% and the expected return of the market is 7%.
Plug the values in the formula and you have:
2% + 1.2 x (7% – 2%) = 8%
In this scenario XYZ is expected to have a return of 8%. But let’s say in reality it achieved a return of 10%.
2%, the difference between this 10% and 8%, is the stock’s alpha (also called Jensen’s alpha).
More Than One Alpha
There is also a different measurement of alpha, which simply compares the stock’s return to the market index’s return. In our example, the simple alpha would be 3%.
I prefer Jensen’s alpha as the measure of alpha because it takes into account the risk-free rate and the market risk premium. But regardless of which alpha you prefer, the thing to remember is that the more positive a stock’s alpha, the better it is at beating its expected return.
There you have it. Beta will tell you the expected volatility of a stock and alpha will tell you how well the stock has done compared to its expected return.
Editor’s Note: If you’re looking for a way to stay bullish without undue risk, you should keep an eye out for an exciting offer from Investing Daily. It’s “the next big thing” from our colleague Robert Rapier, chief investment strategist of Utility Forecaster.
Up, down, sideways… even in the face of rising interest rates… tech selloffs… and anything else Mr. Market throws at you, Robert’s trades are income-generating machines. Watch for details, soon.