If someone tells you a stock went up by 10% last month, therefore clearly ‘smashing it’, what would be your first question back to them? What if they told you their portfolio of stocks overall went up by 10% last month? What would be your response?
In both cases, you would need to ask: well, what did the market overall do? If the stock market as a whole was up 12% last month, then your friend’s portfolio has actually underperformed, as has the individual stock they mentioned.
The performance of a stock, bond, work of fine art, portfolio, or some other asset is always a combination of at least two components. You can add more components if you want to get technical, but two are by far the most important: alpha and beta.
The effect of the overall market (for stocks or for bonds or for fine art, etc.) on the performance of a given asset is known as ‘beta’. Using stocks as our example, every stock can be benchmarked against the market it belongs to. If the stock always moves precisely in line with the rest of the market, it is said to have a beta of 1, such that when the stock goes down, it isn’t considered to have done badly, and when it goes up, it isn’t considered to have done well. Only when it goes down or up by more or less than the market, is it considered to have done well or badly. The degree to which it deviates from the overall market – bad or good – is called ‘alpha’. Beta and alpha are generally measured over a period of time.
For example, let’s say over the last few years, the energy sector within equities has fallen by 20%, and Royal Dutch Shell (RDS) has fallen by 18%. The closeness of those numbers is not surprising, because RDS sits within the energy sector. In this example, we could say that the beta component of RDS’s performance is -20%, while the alpha component is +2%. A stock picker who chose the stock will be evaluated (favourably) on the latter component. Let’s extend the example and say the overall stock market was actually up 10% over the same period. The beta component of the energy sector’s performance is then +10% while the alpha component is -30%. The asset allocation professional who chose to buy the energy market would be evaluated (badly) on that latter component.
The same is true for an overall portfolio. Let’s say your portfolio contains some equity funds plus about 10 stocks. To properly evaluate the performance of your portfolio, it is necessary to understand – at least qualitatively – how the equity market overall performed. Then you can know whether your portfolio has done well or badly. For the purpose of understanding your portfolio, a few percentage points here and there won’t matter, but if your (equity) portfolio is up 5% over a period where the equity market is up 20%, there might be something wrong that needs investigating.
Remember, defining the ‘market’ is crucial for the definitions of ‘beta’ and ‘alpha’ to have any subsequent meaning. Beta and alpha are relative terms that help you to make sense of numbers that might otherwise not have any context.
These terms are used extensively in investment, in ways that extend to much more complex applications that the ones described in this post. Although they can be complex terms, their fundamental essence is easily applied in an everyday investment setting, and they can be powerful tools in helping you make sense of your portfolio.
We refer to lots of linked posts in this post. We hope that by following the links you can answer any questions you might have, but if anything is unclear in this post, or you have any questions relating to anything investment-related, please submit comments or questions in the section below and we’ll do our best to answer them.
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