Is It All Greek to You? More Investment Concepts Explained
While investment theory can be highly technical and, for the most part, is best left to the professionals, it is useful for lay investors to have a basic understanding of terms and concepts that may arise in discussions with their financial advisers and in financial media content. A previous article, “Investment terms you should know”, provided explanations of many of the most commonly-used terms. In this article, we dig a little deeper into investment theory by looking at some concepts and metrics employed by professionals when making buying or selling decisions.
The Greek-letter metrics of returns
“Alpha”, “Beta” and, more recently, “Gamma” crop up frequently in discussions about investment performance and portfolio management.
• Alpha: This is a measure of the extent to which the return of a security outperforms a benchmark such as an index, after adjusting for volatility. Also known as Jensen’s Alpha or Jensen’s Measure after its originator, the US economist Michael C Jensen, it can also apply to an entire portfolio. Thus the performance of a fund manager may be assessed by determining the fund’s Alpha relative to the fund benchmark. Although the actual formula is fairly complicated, you can get a rough idea by comparing actual performance against benchmark performance.
• Beta: This is a measure of a security’s (or portfolio’s) volatility compared with the volatility of the broader market or a benchmark. It is expressed as a ratio, where 1.0 represents the volatility of the broader market. A number above one indicates that the price is more volatile than the market in general. A number below one indicates that the price is more stable.
• Gamma: Although initially used in the context of derivatives trading, “Gamma” has more recently been used to denote the additional value an individual investor can achieve by making more intelligent financial planning decisions, presumably with the help of a trusted adviser. The term was introduced in 2013 by Morningstar researchers David Blanchett and Paul Kaplan in an attempt to quantify the value of financial planning. Blanchett and Kaplan found that a retiree using informed strategies could generate about 1.59% extra return per year. Previously, Vanguard’s “Advisor’s Alpha” analysis had estimated that as much as 3% per year in net returns could be added by following best practices in financial planning.
The risk premium
If you decide to invest in higher-risk assets such as shares, it is because you expect a higher potential return than investing in a lower-risk asset, such as a money market account. The “risk premium” is the compensation you get for taking on more risk.
An investment’s risk premium is measured against a standard “risk-free rate”. Theoretically, the risk-free rate is an investment with zero risk. In practice, it is represented by the yield on a long-term government bond, such as the South African 10-year bond. Thus if the interest rate on the 10-year bond was 9% and your investment returned 12%, you would have received an additional 3% in compensation for the additional risk you took on. Was it worth it? Only if you also factored in the volatility of the investment, as measured by Beta (see above), which turns it into a more complicated calculation.
Note that the risk premium of an investment is not static; it is affected by market forces, including investor sentiment, economic conditions and interest rates.
The risk premium offers a greater appreciation of the link between risk and reward, and explains why a share portfolio should outperform cash and bonds over the long term, while being more volatile over the short term. In the words of Malvika Gurung, writing for Investing.com: “By understanding how the risk premium is determined and why it changes, you are better equipped to navigate the markets, set realistic expectations for your investments, and appreciate the reward you are rightfully demanding for taking a calculated chance.”
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