I have always been a believer that you can judge how bustling and entrepreneurial a city is by visiting it in the middle of a rainstorm. In the true entrepreneurial metropolises, you will inevitably find that, shortly after the first raindrops touch the pavement, a smiling man carrying a selection of umbrellas will approach you and humbly offer his wares. I’ve always appreciated the friendly neighborhood umbrella salesman, and have a collection of rain-protecting devices sitting in my closet as evidence of this (and of my general forgetfulness).
Frequently after such encounters, I’ve reflected that I would make a terrible umbrella salesman. I fundamentally lack the relentless drive to make a sale that the best umbrella peddlers exhibit. But in the middle of a torrential downpour, even I would succeed. This highlights the rather obvious connection between the success of an individual umbrella salesman and the weather. If you wanted to determine whether an umbrella seller was any good, it would not be enough to examine how sales have been over the past month. You would want to know how the weather affected sales efforts, perhaps by comparing these to the sales of other umbrella sellers in the region.
It turns out that money managers are just as impacted by their environment as umbrella sellers, but the connection seems to be less obvious to many investors, perhaps because market movements are not quite as tangible as raindrops.
The Difference Between Alpha and Beta
Suppose you want to evaluate the performance of your investments. You look at your statements and find out that overall, your portfolio returned 15% last year. This seems good in absolute terms, since the average return of the stock market since 1900 is around 10% a year.
But knowing that your portfolio returned 15% last year is kind of like saying an umbrella seller sold 5 umbrellas yesterday – it does not really help you unless you put it into context. Was it raining yesterday, or was it sunny? Was the Super Bowl in town? In the context of investing, was last year 1999 (the height of .com mania) or 2008 (the financial crisis)?
To get a better idea of whether that 15% return is good or bad, you could compare it to the return of the overall stock market. If you have a portfolio that is invested in US Stocks, you could use an index like the S&P 500.
Suppose you find that the S&P 500 actually went up 20% last year. Now that 15% return does not seem so great in comparison. Your selection of individual investments actually subtracted value – you performed worse than most investors in the market, worse than you should have given the external conditions.
Finance theory formalizes these concepts by splitting the sources of return of a portfolio into two parts – what we will call alpha returns and beta returns. Formally, beta measures the sensitivity of a portfolio to the overall market and is a generally a function of how risky the portfolio is. Alpha, on the other hand, measures the difference between the return of a portfolio and the return of an equivalent market portfolio (one with an equivalent risk).
The precise details of how to calculate alpha and beta are not terribly important (see the Further Reading section if you are interested). What is important is to understand that any portfolio has two things that affect its returns: the overall market (beta), and the selection of individual investments (alpha).
We will call part of a portfolio’s returns that are related to the overall market “beta returns” for shorthand, and the part of a portfolio’s returns that are a function of stock-picking “alpha returns” (note this is shorthand and these terms may not appear in other texts). In the umbrella examples, these correspond to weather and salesmanship.