Independently of each other, two friends of mine – Akash here in Berlin and Omar in Canada – have asked me to teach them something about stocks and investment. I was not originally planing to cover that on my blog soon, but here it goes. Initially, I will focus on some general rules and public markets, i.e. stocks and related financial products and instruments. Later on, depending on how the interest in that is, I will also talk about investing one type of private company, some of you might be familiar with – as employers, rather than as investment opportunities: startups.
High Risk – High Reward: On the difference between high alpha and high beta investments
The first thing people that get into investing their money need to understand are two things:
- If it is too good to be true, it probably is not [true].
- There is no such thing as a “free lunch”, in the context of investment opportunities.
On the first point: If we find a good investment opportunity which has a high return in relation to the risks, it has a [high] “alpha”. Alpha is nothing more than simply the excess return beyond an average investment of the same risk. Please take note the end of the sentence here: the same risk. For most people, it is not hard to find investments which have a higher return than the opportunity you found. However, if you look more closely, most of theses opportunities will turn out to be ones with a higher risk. High risk investments commonly are said to have a high beta – at least if their outcomes correlate highly with the general development of the markets! – which is quite different from the alpha many investors are seeking. (Fittingly, one of the most successful websites for Financial markets is called “Seeking Alpha” – now you know why!)
How is a high beta investment different from a high alpha investment, you may now ask?
A high beta investment has a high risk, it’s outcome is very volatile.
A high alpha investment might have a high, or low risk, however, the returns it provides are in excess of that what most investments with the same risk profile normally provide.