I hate to break it to you, but that high school Greek that you thought you had left behind forever is back! As an investor, you’re going to need to get reacquainted. (Unlike your old algebra notes which should be destroyed immediately.)
Let’s start with Alpha.
What’s Alpha, what’s Beta?
Alpha is about bragging rights—achieving higher investment returns than the overall index. A manager of an active portfolio who invests in particular stocks wants to achieve an Alpha of greater than 0. If she has an Alpha of 7, her portfolio beat the index by 7%. (This would be awesome, but rare, because most active portfolio managers underperform the index after accounting for fees, which means their Alpha is negative.) A passive investor will only ever match index returns, minus fees, so her Alpha is close to 0.
Next up: Beta (β) measures how closely a stock moves relative to the index. To understand Beta, let’s look at the volatility in the price of a stock. Volatility relates to the price swings (or variance) in a stock price. The greater the price variance, the riskier the stock, the higher its Beta.
The index always has a Beta of 1.0. A stock whose Beta is close to 1.0 will move up or down along with the direction of the index. For example, the largest stock in the S&P/TSX is the Royal Bank, (RY-ticker symbol), with a Beta of 0.97, so we would expect its price movements and returns to closely mirror those of the index, both up and down.
By contrast, Wheaton Precious Metals (WPM-ticker symbol) has a Beta of almost 2.50. It is more than twice as volatile as the market. If the market goes up 100-basis points, Wheaton Precious Metals is expected to rise faster, perhaps by 250-basis points for each 100-basis point change in the index. And, when the market drops 100-basis points, Wheaton Precious Metals would be expected to drop more.
When a stock has a negative Beta it moves inversely to the index. For example, Dollarama, (DOL-ticker) has a Beta of -0.12. A negative Beta means that Dollarama shares move inversely with the index. Another way to say this is, movements in the index explain very little of the change in the price of Dollarama stock.
Why would you invest in a stock with a negative Beta? Because in a down market, it would not go down as much as the overall market, or possibly even rise, and, therefore, buffer your portfolio from losses.
How can investors use Beta to pick stocks?
A key feature of any successful investing strategy is diversification: investing in asset classes or securities whose returns are not closely correlated. One way to diversify is to select stocks with different Beta values. This way, each of your stocks will respond differently to financial markets or economic events. This will lower the overall risk level in your portfolio.
For experienced options investors, “Greeks” represent dimensions of risk. Delta is the sensitivity of an option’s price to a change in the underlying price of the security. Gamma is the sensitivity of the rate of change in Delta to the underlying price of a security. Yeah, “It’s all Greek to me!”
The takeaway is every investor should understand the terminology used for her own investments. If you buy individual stocks, consider Beta. If you work with an active portfolio manager, ensure that you know what her/his Alpha is. If you’re investing in options or other derivatives, better brush up on those other Greek letters—and keep the ouzo handy…