Most of the time, we must (to reach our goals) take on more risk to make more money. The money you earn above your purchase cost of an investment is your return. The money you put into an investment is called your principal. Ideally, we’d like to see a high rate of return on our principal when we make an investment. As a rule, we want our money to grow because that is how we use the magic of compounding to achieve our financial goals.
The better the rate of return (usually expressed as a percentage, similar to bank interest rates), the faster our money grows and the quicker we reach our goals. It follows that if we choose investments with the highest possible rate of return, then we can achieve our goals and become wealthy much faster. The problem is that with high returns comes high risk. Investing is about probabilities when your returns are not guaranteed. You may find an investment with a potential to double your money (a 100% return), but you will likely go broke in the process.
Perhaps the best way to look at the potential return on an investment is to consider the following simple equation:
Return = Cash + Alpha + Beta
If you thought, “That’s Greek to me,” you are correct. Alpha and beta are the first letters of the Greek alphabet. Cash is, as we said above, what you would earn on your money invested at the risk-free rate. That rate is set by central banks, and there isn’t a lot we can do about it. Since cash currently does not beat inflation, investors don’t invest in cash or cash equivalents for any lengthy period.
We can simplify beta by saying it is the average amount of return you can expect from a given type of security’s benchmark beyond the return of cash. A benchmark is a sort of standard that gives an idea of how a different kind of investment is doing. If you understand golf, you can think of beta as par. It is the return you should be making if you manage to track the benchmark successfully.
When investors talk about their portfolio, they mean the total collection of all investments that they own. Some investors may only hold one investment such as an annuity, and others may contain hundreds of different stocks, bonds, and other securities. Some investors may have different “baskets” of money for different purposes, such as having a “retirement portfolio” and a “discretionary portfolio.”
There are many benchmarks because different people have different ideas about what is best. In the stock market, for example, the Dow Jones Industrial Average is the most frequently reported index of stock performance, and it can serve as a benchmark. Most financial professionals use the S&P 500 Index as the default stock benchmark. Note that this only applies to stocks; you’d use a different benchmark for bonds. Beta is very easy to obtain since the advent of mutual funds and exchange-traded funds (more on those later).
For example, if you want to achieve the same return as the S&P 500 index, you can just buy all the stocks in the index. If you did this, your portfolio would grow at the same rate as the S&P 500. It would also decline at the same rate if markets went down. Investors in the market for the long haul don’t fret about this risk because the trend of markets has been upward for the entire history of the market. I call this the market’s bullish bias.
The term alpha is spoken of on Wall Street in tones of reverence. Investors use alpha to mean the profits made in addition to and beyond the benchmark. If the S&P 500 went up 10% in a given year and an investor had a 21% return, then all of the profits beyond the benchmark’s 10% is alpha. In other words, alpha is a measure of how much you beat the market. Recall our basic premise that you cannot beat the market.
You may find alpha in a given year, but you will fall below beta in the end if you keep seeking alpha. There are those that have consistently found alpha, but they are legends. They are the Titans of Wall Street, financial gods dwelling among men. They are the unicorns. Always keep in mind our other premise: You are no unicorn.
Wall Street in New York City was the home of the first stock exchange in America. Legend has it that stock traders would gather under a tree and conduct business. Later, the New York Stock Exchange was formed very near that fabled tree. Since that time, the term “Wall Street” has been used to mean financial markets in general. When investors say “there is no free lunch on Wall Street,” they are not speaking of the physical location but rather how financial markets work in general.
Last Modified: 07/11/2018
This work is licensed under an Open Educational Resource-Quality Master Source (OER-QMS) License.