| Beta measures the volatility of a stock or portfolio in relation to the entire market. A beta of 1 suggests that the stock’s or portfolio’s price will move in line with the market (market up 10% suggesting the stock or portfolio will be up 10%). A beta less than 1 suggests that the stock or portfolio will be less volatile than the market. A beta greater than 1 suggests they will be more volatile than the market. If a stock’s or portfolio’s beta is 1.2, it is thought to be 20% more volatile than the market (market up 10% suggesting the stock or portfolio should be up 12%).
If the stock or portfolio in the last example is up 15% (rather than the 12% expected) the 3% return in excess of the expected beta is said to be the stock’s or portfolio’s alpha. A positive alpha is the extra return rewarding an investor for taking additional risk. |
Sophisticated investors (institutions, pension plans and wealthy individuals) want to know how much of their portfolio return is attributable to the market and how much to factors other than the market (like asset allocation, stock selection, market timing etc). If their portfolio increased at the same rate as the market, and the portfolio's beta was 1, their managers haven't added any value for the period.
At PŮR, core portfolios are engineered to capture beta cheaply. Alpha strategies can be added to build the potential for additional returns.
- Getting the market return for taking less than market risk is good.
- Getting more than the market return for taking only market risk is good.
- Getting less than the market return for taking risk equal to or greater than the market is what the median mutual fund has done over the long term (and many short term periods as well!). It's bad!
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