In the last decade, investors have been erroneously assigning their portfolio returns as Alpha. Though passionate, many of these investors are unable to truly measure whether these returns are a product of outperforming market indices, and skill. While non-skilled based returns (Beta), provide an investor with decent returns, they are often susceptible to hidden market risk. Investors who want to avoid risk, and simultaneously earn steady returns that beat the market should establish a keen understanding of how Alpha and Beta differ.
Alpha measures the performance of your assets in comparison to a benchmarked index such as Nifty or Sensex. If your assets gained 5% in comparison to Sensex, which gained 2%, then your Alpha is considered to be “3” i.e. your assets performed 3% better than the benchmarked returns. On the corollary, if in case your assets gained 2% while the Sensex gained 5%, your Alpha is “-3” it means the performance of your investments was lower than the average market gains.
Beta, on the other hand, refers to the sensitivity of your assets’ performance in relation to the benchmarked index. For example, if your assets have a Beta of 1, they move in line with the market rally. If they have a Beta greater than 1, implies your assets are more volatile and will rally higher than the market both upwards and downwards. A Beta higher than 1 indicates assets will gain with greater returns in a bull run and will lose much more value in case of a bear run.
Now, every investor likes to maximize their returns on a given portfolio. In chasing the same, the two things they get blind sighted with are risk-adjusted return (which in fact creates Alpha) and volatility of the underlying portfolio. When 2017 ended every investor created wealth in excess of 30% in Indian equities capping a great year for equity investors. However, come 2018, the same investors again began chasing Alpha, and as the year drew to an end, mid-cap and small-cap stocks declined by -13.5% and -23.5% respectively while Nifty ended hardly 2% positive even as the journey was extremely volatile
Refer to the chart below
Hence was your quest for Alpha justified??
Can volatility alone lead to wealth creation over time?
Investors usually follow the path of chasing Beta in expectations of an economic upturn. Investors favouring high Beta assets often argue that while volatile investments have a tendency to lose some value, they almost immediately gain that in the next upswing. However, there is a big difference in these series of returns. Let’s look at an example:
Mr. A invests INR 10 lacs in a high Beta asset. If the portfolio drops by 10% in its first year the asset value drops to INR 9 Lacs. During the next upswing, Mr. A gains 10% bringing his portfolio up to INR 9.9 Lacs. Despite the increase and decrease in asset value is exactly the same mathematically, Mr. A has still lost INR 10k at the end of the 2 years.
Due to differences in returns across sectors, investors need to justify the investments in volatile stocks with greater expected returns to compensate for the compounded loss of investments due to volatility over a period of time. And, while volatility has the possibility of bringing quick returns in the short term, it is quite detrimental for long term asset creation. While there is no right or wrong strategy, one must really evaluate what the overall objective of the investment is. While high Beta assets have their benefits in terms of high returns in an upward trend, it is imperative you balance that with a well-diversified global portfolio of assets to balance out the volatility.
What does this mean for you as an investor?
Preservation of wealth is as important as the creation of wealth, especially wealth which has been generated out of a volatile asset class, like equities. Investors are better off not riding the same volatile cycle which helped them earn their wealth in the first place because the wealth creation cycle, especially in equities, is non-linear and may lead to significant wealth erosion. In search of Alpha, investors tend to expose their portfolio to higher volatility which significantly impacts wealth creation. In an equity downtrend, a highly volatile investment portfolio generates Beta which outplays Alpha created, if any, and results in wealth erosion.
Hence investors are better off reallocating a part of their investment proceeds into a more stable asset class with a predictable return on investment especially if the same investment is backed by the most stable currency in the world, the USD.
Sources: http://www.niftyindices.com/market-data/advanced-charting?Iname=Nifty%20High%20Beta%2050; https://economictimes.indiatimes.com/wealth/invest/should-you-opt-for-high-risk-Beta-stocks-over-quality/articleshow/53568998.cms