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The Importance of Alpha & Beta In Stock Picking

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As investors, it is always easy to mask how good we are at stock picking and fool ourselves into believing that we are better than we actually are. A lot of the times, this is because we do not pick the right goal posts to benchmark our annual performance on. But transparency must be everything when evaluating our stock picking performance. To kid ourselves is to do to more harm than good.

People often get obsessed with ‘beating the market’ like it is some organic thing that drives stock prices. We would be good to remember that the ‘market’ was created by companies, not the other way around – what drives it over the long term are the individual company performances

One of the most common methods of bench marking is the year to date performance of your portfolio against a major index such as the S&P. This measure is known as beta. Beta is defined as the return generated from a portfolio that can be attributed to overall market returns. Exposure to beta is equivalent to exposure to systematic risk. As a performance benchmark it does have some drawbacks:

  1. This doesn’t help when you have securities from multiple indexes
  2. It doesn’t help measure individual stock performance
  3. It doesn’t take currency fluctuations into account

Let’s say I have a portfolio of 10 stocks who are all listed in the S&P. Last year my portfolio grew 12% and the S&P grew 10%, this would indicate that my actual gains are 2% – still not bad. However this becomes difficult to measure if half of that portfolio was made up of stocks from the FTSE 100 and half from the S&P.

This is where the measure of Alpha comes in. Alpha is the portion of a portfolio’s return that cannot be attributed to market returns, and is thus independent from market returns. Imagine my portfolio’s base currency is USD. I bought Halma, a UK listed stock. Halma grew 10% last year (great), but the USD appreciated against the GBP by 13%. If I sold my Halma holdings and converted the GBP back to USD I would have lost 3% – even though the stock was up. Additionally if I bear in mind the beta gains of 8% of the FTSE index that year, my returns attributed to my individual stock picking skills look even worse.

So to be truly transparent investors need to focus on beating Alpha. One problem is the difficulty in measuring it, too much data is needed to compute in manually and there are not many portfolio services out there that offer this function.

This is where we come in. Robur’s portfolio management tool as an individual stock overview option that takes into account forex movements and Beta movements, giving a final Alpha score. It looks something like this:

alpha-and-beta

 

Let’s focus on the German insurer BASF near the middle of the table. We can see that the value of the share price in Euro (the share price currency) has increased by 11.3%, however the Euro lost 17.3% against the USD (this portfolio’s base currency is USD), meaning that overall the stock lost money when valued in its base currency. Beta movements were also positive against the stock, which meant a final negative value for Alpha of 13.1% – even though the stock rose in value in its own currency.

This type of transparency can be brutal sometimes (believe me the rest of this portfolio is not showing such impressive Alpha returns), but this is our nest egg we are talking about. The more honest we are about our stock picking performance the better.

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