Three roads to 'alpha' and the simple beta route to wealth accumulation

ALPHA, beta, delta, gam-ma, theta - there is a lot of "Greek" in investment language.

A lot of it has to do with the options market. But two terms newbie investors will hear a lot of are "alpha" and "beta" - the "A" and "B" of investing.

Let's start with beta. Technically, it refers to the volatility of a stock relative to the broad market. So, a high beta (above 1) stock has a greater volatility (think of that as risk) than the broad market index. Conversely, a low beta (below 1 but above 0) stock has lower volatility/risk than the broad market index. And a beta of 1 means the stock tracks the movements of the broad market index.

But in popular usage, the term beta has taken on that specific meaning of what is technically called "beta of 1" - meaning the tracking of the broad market. So, typically an exchange traded fund that mirrors a market index, whether it's the Straits Times Index or the S&P 500, will have a beta of 1 against that index.

Alpha refers to "excess returns" - or the ability to beat the broad market. In popular language, alpha is about "beating the beta". For example, over the past 12 months, the S&P 500 gained 12 per cent but Microsoft surged nearly 20 per cent. That's alpha for shareholders of Microsoft.

There are a number of ways investors can try (and we emphasise "try") to beat the beta. Here are the three most common ways.

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Stock and theme selections

The first method is savvy stock selection based on fundamentals such as a sustainable and defensible business model; good growth prospects; a strong enough balance sheet to withstand occasional economic storms; and reasonable valuations.

The second is selection of themes that can drive sectoral outperformance over time. An outstanding example is the digitisation of the global economy that helped drive US technology stocks' outperformance over the past 10 years - with the S&P 500 rising 250 per cent but the S&P 500 information technology sector surging 542 per cent.

So, we can easily understand why everybody wants to generate alpha from their investments. But it is not an easy feat. Indeed, even among financial professionals, the ability to consistently generate alpha is few and far between.

A study by S&P of fund performance data over 15 years from 2001-2016, found only 8 per cent of large-cap funds matched or beat a simple S&P 500 index fund. The percentage of small cap funds that matched or beat their benchmarks was even lower at 7 per cent. And the percentage of mid-cap funds that did the same was only 5 per cent.

So, what does that mean in practical terms for investors? By all means, buy single stocks if you are comfortable with analysis and stock-picking. By all means too, pick sectors to focus on if you think you can spot the big trends before they occur.

Timing the market

Market timing is the most difficult of the roads to achieving alpha. And here's why: Sound economies are, over time, much more supportive of bull markets than bear markets.

The US, the world's largest economy, saw, between 1945 and 2017, almost six months of economic expansion for every month of economic contraction.

And as a result, over the period 1926 to 2018, the average bull market (periods when stock prices rise more than 20 per cent) in the US lasted nine years, with average cumulative total returns of 474 per cent. The reverse - US bear markets (periods when prices fall more than 20 per cent) - lasted only 1.4 years, with an average cumulative loss of 41 per cent.

So, if you are not confident of market timing your investments, or sniffing out the big trends, or picking good stocks, you can still benefit off the beta.

Stock markets in sound economies may go up and down. But generally, over time, they revert to mean on rising trendlines. If you do no more than ride the beta, there is a reasonable likelihood that your investments will be worth a lot more over the decades. Historically, stocks have outperformed bonds and cash.

Over the period 1926 to 2016, US stocks registered compound annual returns of between 10 per cent (for large companies) and 12 per cent (for small companies). US Treasury bills earned only 3.4 per cent per year. Inflation, on the other hand, eroded the real spending power of cash by 2.9 per cent a year.

Taking a shorter time frame, between 1998 and 2017, US$1 invested in US stocks would have registered compound annual returns of between 7 per cent (for large companies) and 10 per cent (small companies). US Treasury bills returned only 1.9 per cent a year. That is, their returns fell behind the inflation rate of 2.1 per cent a year.

• Lim Say Boon is Chief Investment Strategist at CGS-CIMB Securities.
• This is the fifth instalment of Invest & Grow, a weekly 10-part series that aims to help new investors get started on their investment journey.