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Friday, September 08, 2006

Alpha and Beta - Market Risk

One of the financial theory is to split the risks related to investment of various instruments into systematic (overall market risk) and non-systematic risks (company specific). Within the theory, by investing in a basket of stocks with different economic characteristic, non-systematic risks can be eliminated (according to the theory that is, minimize is probably a more accurate term).

Please note that buying a basket of dotcom does not eliminate non-systematic risks as a downturn in technology will pull the whole basket down.

This leave market risks where the greek alphabet comes in. Beta then dictates the risks of the portfolio, and an investor can only expect to earn higher return by taking higher risk. In this case, risk means the possibility of fluctuation of the value of the portfolio at any point in time. For example, a stock portoflio that are on average likely to swing as much as the market (beta = 1, usually it is DEFINED that broad market index such as S&P or FTSE100 has beta of 1) is considered less riskly compared to a stock portfolio with a beta of 2 (i.e. one that if the market moves 1%, it will move 2%, up or down, on average). In the long run, both portfolio are expected to go up, and the one with beta=2 will go up more than those with beta=1 over very long period of time to reward the investor for taking extra risks.

So, if a portfolio performs better at a given beta, the fund manager is accredited to have produced a +alpha (and vice versa). Alpha therefore describe the fund manager's skill.

Another point to note is that Post 1999+ broad market index can be said to be no longer reflecting the 'market accurately' because these index contains some very large company that makes up a big composition of the index (big company created via M&A etc). In certain market such as the eastern european market, the state ex-monopoly telecom can account up to 50% of the total market capitalisation of the index. Even in UK, the top 8 companies (BP,VOD,GLK,HSBC etc) account for >50% of FTSE100's market capitalisation.

The movement of these mega company shares now has disproportionately effect on the market-cap- weighted index. Because of thise also, Beta measured using the broad market index as reference may not accurately reflect the porfolio risk either.

posted by Casper @ 3:44 PM  

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