Monday, 6 May 2013

What does 'generating alpha' mean?

If you have started to look into investing and have bought a few investment books or (more than likely) surfed the web to work out how to make money investing in the share market you will almost certainly have come across the term "alpha" and seen the investment communities obsession with generating it.
So what is alpha and how and why do investment professionals try and generate it?
What is alpha?

If I simplify it right down (and for you who understand the complexities of this don't bite my head off - this is meant to be a simple explanation), you can get basically two returns from any given investment

  • Alpha: returns which are uncorrelated with the general share market returns; and
  • Beta: Those returns which are correlated with share market returns
As you may have read in my post before on risk - generally speaking, when you seek higher returns you must accept a higher level of risk.  In order to achieve a higher return than the market you need to have a portfolio that has a higher beta (volatility or risk factor) than the market.

However alpha is different - if you generate alpha you are generating higher returns which are uncorrelated with market returns.  It is an abnormal rate of return above what would be expected from an equilibrium model like the capital asset pricing model (CAPM).

Why do investment professionals (and others) focus on alpha?

People focus on alpha because it is, if you can achieve it, a way of achieving excess returns for the same level of risk.  

It does not take a particularly good investment professional or fund manager to invest in risky stocks to try and make and higher return (i.e. to seek a beta return) - all they need to do is to get higher risk stocks and stick them in their portfolio in order to leverage up their returns in good times (however this also leverages them to the downside!)

Alpha returns are preferred because it is out performance of the market in good times and in bad times.  An investor who is achieving alpha should be getting better than market returns on both up markets and down markets because their performance is, at least partially, uncorrelated with market returns.

How to investment professionals (and others) seek alpha?

There is no silver bullet here - whenever you hear of ways to invest or techniques to try and beat the market - this is people seeking alpha.  They are seeking ways to outperform the market without taking on more or excessive risk.

Some people use a fundamental research driven approach.  They believe that if they understand the stocks they are investing in better than the general market then they can generate incrementally better returns than the market is generating.  This is the view of the world that I subscribe to.  I don't believe that you can always perform better than the market and I do not believe that you can be better all the time - however I believe that if you do your research well and pick your stocks and investments well, then in the long run you should be doing better off than if you held a composite of good stocks and dogs.

Others believe in charting in technical analysis to try and achieve this alpha.  They believe that the market is fundamentally emotionally driven and if you look at indicators of the markets emotions which they believe can be seen from indicators in performance and movements then you can get in front of this emotion and profit and generate a higher rate of return.  Personally, I don't subscribe to this but plenty of people do.

All the other investment techniques you see out there are all focused on this alpha.  So when you hear someone talk about what they are doing to try and achieve alpha or a better return - you now know that they are just trying to beat the market for the same level or risk

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