IntroductionWelcome to another episode of The Investing Iguana, with your host, Iggy. Today, we’re diving into the fascinating world of investment metrics, specifically focusing on two key terms: alpha and beta. These terms are often thrown around in investment circles, but what do they really mean? And more importantly, how can they help Singaporean investors make informed decisions? Let’s find out. y = a + bx + uAlpha and beta are two measures derived from a linear regression equation. If you’re not a fan of equations, don’t worry! We’ll break it down in simple terms. The basic model is: y = a + bx + u Here:
Let’s start with beta. Beta measures the systematic risk of a security or a portfolio compared to an index like the STI. For instance, many growth stocks would have a beta over 1. A Singapore Government Bond would have a beta close to zero because its prices hardly move relative to the market as a whole. Beta is also a multiplicative factor. For example, an ETF that aims to deliver twice the daily return of the STI would have a beta very close to 2. If beta is -2, then the investment moves in the opposite direction of the index by a factor of two. Most investments with negative betas are inverse ETFs or hold government bonds. Beta also indicates when risk cannot be diversified away. If you look at the beta of a typical unit trust fund in Singapore, it’s essentially telling you how much market risk you’re taking. Beta Beta is also a multiplicative factor. For example, an ETF that aims to deliver twice the daily return of the STI would have a beta very close to 2. If beta is -2, then the investment moves in the opposite direction of the index by a factor of two. Most investments with negative betas are inverse ETFs or hold government bonds. Beta also indicates when risk cannot be diversified away. If you look at the beta of a typical unit trust fund in Singapore, it’s essentially telling you how much market risk you’re taking. AlphaNow let’s move on to alpha. Alpha is the excess return on an investment after adjusting for market-related volatility and random fluctuations. It tells investors whether an asset has consistently performed better or worse than its beta predicts. Alpha is also a measure of risk. An alpha of -15 means the investment was far too risky given the return. An alpha of zero suggests that an asset has earned a return commensurate with the risk. Alpha of greater than zero means an investment outperformed, after adjusting for volatility. When fund managers talk about high alpha, they’re usually saying that their managers are good enough to outperform the market. But that raises another important question: when alpha is the “excess” return over an index, what index are you using? For example, fund managers might brag that their funds generated 13% returns when the STI returned 11%. But is the STI an appropriate index to use? The manager might invest in small-cap value stocks. These stocks have higher returns than the STI according to various models. In this case, a small-cap value index might be a better benchmark than the STI. There’s also a chance that a fund manager just got lucky instead of having true alpha. Suppose a manager outperforms the market one year; does this mean they have skill or just luck? This question underscores why it’s essential to look at long-term performance and consistency when evaluating fund managers. ConclusionThat’s all for today’s episode! We hope this discussion on alpha and beta has been enlightening and will help you make more informed investment decisions. Remember, investing is not just about following trends; it’s about understanding what drives those trends and making decisions based on solid data and analysis. Stay tuned for more insights from The Investing Iguana!
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