Monday, February 15, 2010

Alpha & Beta

If you read and listen to financial news enough two terms will come up -- alpha and beta. These are Greek, literally and metaphorically, to most people. The definitions on offer don't help much. Here is what Investopedia says about Alpha:
A measure of performance on a risk-adjusted basis. Alpha takes the volatility (price risk) of a mutual fund and compares its risk-adjusted performance to a benchmark index. The excess return of the fund relative to the return of the benchmark index is a fund's alpha.

And Beta:
A measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. Beta is used in the capital asset pricing model (CAPM), a model that calculates the expected return of an asset based on its beta and expected market returns.

What does that all mean? Well, if you really want to boil it down it's kinda like this: alpha is skill and beta is luck.

That's not exactly it, but it's close enough that if you swapped skill for alpha and luck for beta when you are reading financial news, then it wouldn't be too far off.

For example, Megan McArdle wrote this not too long ago:
The fees are hardly the worst part; more worrying is that many public pension funds and other public trusts are assuming risks they don't necessarily understand. They think they're gaining alpha--higher expected value on their investments. But often they're confusing alpha with beta, which is to say they're getting higher returns not because they're making good investments, but because they're taking on more risks.

I don't think I need to convince many people that high-risk, high-return investments are a bad way for public pensions to try to deal with their massive unfunded liabilities.

I'll replace alpha and beta and I think it makes more sense to most people:
The fees are hardly the worst part; more worrying is that many public pension funds and other public trusts are assuming risks they don't necessarily understand. They think they're gaining skill--higher expected value on their investments. But often they're confusing skill with luck, which is to say they're getting higher returns not because they're making good investments, but because they're taking on more risks.

I don't think I need to convince many people that high-risk, high-return investments are a bad way for public pensions to try to deal with their massive unfunded liabilities.

Sorry if any of you thought this was condescending. As you know, FLG hates jargon.

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