An idiot's guide to rating investments from alpha to beta
There are myriad classes and, for the beginner investor, it must be a bit confusing. So let me give you an idiot's guide to rating investments from "alpha" to "beta". Stick with me.
Alpha is an expression from the funds management world used to describe the "excess return" of an investment relative to a benchmark. It is used to denote how much value above the average is being added to your investment returns.
Beta, on the other hand, represents the volatility of an investment relative to the market. All you need to know here is that a beta of "1" means an investment will move in synch with the market and a low-beta investment moves less than the market.
So a beta of "-1" is an investment that moves in the opposite direction to the market and a beta of "2" is an investment that moves twice as much, and in the same direction, as the market.
I like to think that alpha means "action" and beta is "boring".
With those little definitions in mind, let's now look at the most common investments and rate them from high alpha (a lot of action) to low beta (no brain required).
Building a business is a very high alpha investment - high activity, high risk - but it is where all really wealthy people made their money.
Your career is also massive alpha: getting up, going to work, coming home for half your life. It is also, rather amazingly for a high-alpha investment, about the lowest-risk investment you can make. In terms of risk and reward, investing in yourself is one of the best investments in the whole world.
Then we come to traditional investments that are high alpha. These include direct investment in equities and property.
I have put these on a par because, if you manage your own property investment or equity investment, they are both hard work for very similar returns.
Both are very involved and both require a skill set. Both are high alpha, high activity with significant risk. They suit you only if you can service the need for action.
This also makes the point that when weighing up which asset class is the best, the answer is the one you will enjoy the most, know the most about and are most suited to managing, because both are very different activities.
So it is not really which asset class is the best, it's which one you prefer to expend your alpha on.
Then comes a big drop in alpha to the first of the high-beta investments. These include managed funds, listed investment companies and some exchange traded funds (ETFs). They also include the large retail and industry balanced super funds.
These investments are marketed as if the managers add alpha but, really, most of them are benchmarked to an index and the moment you benchmark a professional, even if they consider themselves an alpha-adding manager, they unavoidably start to hug the benchmark.
Their investments will also become diversified across a lot of individual investments and, because of that diversification, these funds will never set your hair on fire despite the marketing and despite the fees.
Some funds, such as those focused on smaller companies and special assets or situations, may be more volatile and appear alpha-oriented. But even they have their benchmarks and their alpha compared with those benchmarks is more of a beta in the end even if it is more exciting.
Beta investments are things like index funds and passively managed ETFs - they do what they say they'll do on the box: mechanically match an index, a market, a sector.
They can be volatile, as volatile as the market they represent, but no one is working them; they just represent an average, nothing else, with low fees.
Finally there are low-beta investments. These are investments that offer no value above the expected return. They are predictable and low risk and don't require you to sweat them to get a return.
They include everything that offers no growth, including hybrids, cash, term deposits and money under the mattress.
I know a lot of people become highly concerned about the returns on these investments but, really, the main point is that you are parking your money out of harm's way instead of driving it.
The returns used to be enough to live on but not any more - pushing low-risk investors into more risky investments.
The most common mistake on this rating system is taking on a high-alpha role yourself but not giving it the attention it requires.
The second is the biggest rort in the investment industry: paying an alpha-style fee when it's obvious from the structure you're only ever going to get a beta-style return.