One of the biggest debates in the investing community is whether the average investor should look for alpha or beta results from his or her portfolio.
What’s the difference? Let’s take a look at each investment style and then you can decide which one best fits your needs.
The Alpha Investor
You’ll often hear active investors refer to their “alpha.” This is basically the amount by which they have exceeded (or underperformed) their benchmark index. For instance, if you invest primarily in US stocks, you might use the S&P 500 index as your benchmark.
If the S&P 500 was up 5% over a given period of time, but your portfolio was up 8%, your alpha would be +3. If, on the other hand, your portfolio was only up 3%, your alpha would be -2. Alpha is basically the amount by which your return beats or lags an index with a similar risk profile.
Most investors, given the choice, would love to beat the index every year. Why would you want to settle for matching the index when you could try to exceed it? Well, beta investors might contend that very few, if any, active managers regularly beat the index, and that many actually under-perform. So, why bother trying?
The Beta Investor
“Beta” refers to the degree to which a given investment or portfolio is more or less volatile than its benchmark index. A fund with a beta coefficient of 1 implies that it will move with the market. A fund with a beta of less than 1 will be less volatile than the market; a fund with a beta higher than 1 will be more volatile than its benchmark index.
Beta investors are usually passive investors. They are not looking to outperform the markets. They prefer to take the, “If you can’t beat ‘em, join ‘em,” approach to investing. They will accept returns that simply match the index of their choice because they expect that markets will rise throughout their investing lifetime, as they have historically.
That begs the question: what if those historical trends don’t hold true? What if markets take a dip, especially within a few years of retirement? One of the problems with matching the index is that you’re going to have periods of negative returns. You can actually lose money over lengthy periods of time, as many passive investors have during the 2000 to 2010 time frame.
Beta investors would simply remind us that we need to reduce our investment risk tolerance as we age so that we’re not heavily invested in stocks during the 5 years before we retire (i.e. personal investment portfolio asset allocation). They would also caution that, for this strategy to work, you need to be able to sit tight through the downturns. If you sell during those drawdown periods, you’re likely to end up with negative returns. To match the index, you have to stay with it.
Many investors, including myself, aren’t terribly concerned with how they perform relative to any index. They just want to see their hard-earned cash grow over time with smart investment decision-making. Losing 8% in a year when the market was down 14% is cold comfort to the absolute return investor.
Absolute returns simply refer to the amount your portfolio has gone up or down over a given period of time, regardless of how any index performed over that time frame. But how do you achieve consistently positive absolute returns? There are probably hundreds of answers to that question. The key is to find the investment style that works for you.
Which Is Better?
Both alpha and beta investors can be very passionate about defending their chosen investment style. Alpha investors contend that many people can and do beat the indices quite regularly. They are not interested in simply matching the index, and they hate the idea of losing money.
Beta investors believe that the broad stock market indices will be positive over time, so they are comfortable gradually adding to their positions and sitting tight for the long term. They believe that negative returns for a short period of time are part of the cost of investing. They’re confident they’ll be ahead and have the money they need to retire.
Try a Hybrid Approach
Some investors are hardwired to look for alpha. Others don’t trust in their ability to achieve alpha, so they take the beta route. Both are acceptable as long as they’re working. If you’re trying to use a beta investing style, but you just can’t keep your fingers off the sell button, you may want to look at some alpha strategies or try a hybrid approach.
There are endless combinations of hybrid investment strategies. You could divide your investment capital into two pools, using a beta style with half and an alpha style with the other half. See which one performs better over the course of a year. Which one made you feel more comfortable? Could you try out a different alpha strategy to see if it works better for you?
In the end, investors need to put their money to work in a way that fits their age, skill set, income, and risk tolerance. It can take some time, but finding what works for you is the best way to become a successful investor.
What’s your investment style: alpha, beta, or hybrid?
(photo credit: marekuliasz)