Every specialized field has jargon that is virtually incomprehensible to those who aren't familiar with the subject matter. For example, the legal profession is riddled with uses of antiquated Latin terms like "mens rea" and "res judicata" that only frequent Law and Order watchers are likely to know off the top of their heads. At least among lawyers, one common explanation for why people seem to try deliberately to obscure other people's comprehension of ideas is that if most people understood what you were talking about, they'd never pay you hundreds of dollars an hour to talk about it.
The world of finance also has its share of confusing language. Finance's unique combination of mathematical and social sciences makes the field a linguistic battleground among academics. While some try to explain concepts in flowery language, others retreat to equations and technical discussions. It's this confluence of viewpoints that has introduced the Greek letters alpha and beta to mainstream finance, and several others from further down the alphabet also appear in more specialized contexts. So if you've ever worried that you'd have to go back to school to understand references to Greek letters, this article will hopefully ease your mind.
Alpha and beta
The use of alpha and beta in finance has its origin in modern portfolio theory and the capital asset pricing model, which together are one method analysts use to derive current prices of financial assets and to explain the way prices of various assets fluctuate over time and in relation to each other. In simplest terms, the theory assumes that the return of any given asset can be divided into two separate components. One component is unique to each particular asset and is unrelated to the behavior of any other asset. The other component reflects the way in which the asset's return is related to the return of the overall market for similar assets. The combination of these two components explains the way an asset's price responds to changing market conditions.
In mathematical terms, the breakdown of returns into two components is expressed by a relatively simple equation:
asset return = alpha + (beta * market return)
In this equation, alpha is the component that is unrelated to the market and beta is the component that reflects the sensitivity of the asset's return to the overall return of the broader market. If you accept the assumptions of the capital asset pricing model and modern portfolio theory, then knowing the alpha and beta coefficients for an asset gives you a great deal of information about how you should expect the price of that asset to behave under certain market conditions.
Beta: measure of risk
The beta coefficient provides a measure of how a certain asset's price will move in relation to the overall market. A beta of 1 indicates that the asset's price tracks the overall market; if a broad market index moves up 1%, then you can generally expect the asset's price to rise 1% as well. Indeed, if you look up the beta coefficient for an index ETF like SPDR Trust
Many stocks and broader stock portfolios have positive beta coefficients. However, there is no requirement that the beta coefficient be positive. A beta of 0 suggests that the price movements of a given asset are not affected at all by the overall market. A negative beta indicates that one can expect the price of a given asset to move in the opposite direction of the market. For instance, a beta of -1 would describe an asset whose price moves down 1% when the overall market goes up 1%. ETFs that track the inverse of an index, such as the ProShares Short Dow 30
Because one of the fundamental tenets of investing is that those who take greater risks should receive greater returns as a reward, the beta coefficient helps investors to pinpoint the portion of an asset's return that is due to the level of risk. If, for instance, a stock portfolio earned a 20% return while the overall market gained 15%, you might think at first glance that the portfolio was managed well. However, if the beta coefficient of the portfolio shows that the manager took twice as much risk to gain just an extra 5% of return, you might have second thoughts about whether the manager's decisions were prudent or just lucky.
Alpha: outperformer or underperformer
The alpha coefficient is what distinguishes the return of a particular asset from the returns of other assets within a market. It explains how the asset's return deviates from the returns of other assets that involve similar levels of risk. In trying to choose securities for their portfolios, money managers seek to make the alpha coefficient of their portfolios as high as possible. In essence, a positive alpha means free money for a portfolio's investors; a positive alpha means that investors earned a higher return on their investment than was explained by the risk that they took. Conversely, a negative alpha indicates that investors took more risk with a given portfolio than was justified by the portfolio's return.
It's important to understand that the alpha and beta coefficients aren't fixed in stone but rather constantly change over time. To calculate these coefficients, you have to choose a particular historical time frame over which to gather the data for your calculations. As a result, a single asset can have many different alpha-beta combinations depending on the period you choose.
As ways to express financial concepts, alpha and beta are relatively simple. The use of other Greek letters in the financial theories behind pricing of options, however, is far more complicated. The second part of this article turns to these other letters.
- It's All Greek to Me, Part 2
- Beta: The Alpha and Omega to Risk Analysis?
- Hedge Fund Wizards
- Why We Avoid Options
If you want a lot of alpha without a lot of beta, get through the Greek and take a look at Motley Fool Champion Funds. Fool fund expert Shannon Zimmerman looks far and wide for funds that will produce exceptional returns. You can see for yourself with a free 30-day trial.
Fool contributor Dan Caplinger took Latin instead of Greek, but he can still decipher a letter here and there. He doesn't own shares of the companies mentioned in this article. The Fool's disclosure policy translates in any language.