Alpha and beta are risk ratios used to calculate a potential investment’s likelihood of future success. By calculating various risks, investors can make more educated decisions. Alpha and beta are proponents of modern portfolio theory (MPT). The MPT is a framework that uses the performance of investments to estimate the expected return compared to the level of risk. Modern portfolio theory attempts to assure investors which investments have a higher likelihood of success, given the risks they are taking on.
Alpha is derived from comparing the return on investment to a certain index or benchmark. For example, alpha might be the rate a recently purchased stock grew or diminished compared to the S&P 500. If their investment’s growth outpaced the S&P 500, one would say it has achieved “alpha.”
Beta, on the other hand, looks backward and measures an asset’s past volatility relative to a particular market. Before investing, beta would tell an investor how well a potential investment echoed the S&P500 over its existence. These two concepts are vital tools for every investor looking to make informed investment decisions.
Alpha measures the return on an investment compared to a market index or benchmark. Let’s say your portfolio manager invested in a particular stock. If that stock were to go up 15% during the same time the S&P 500 rose 10%, your alpha would be 5. However, if your stock rose 5% less than then our benchmark (in this case the S&P 500), the alpha would be -5. An alpha of zero means your investment rose or fell in the precise manner your chosen index did. While alpha is a percentage, it is commonly presented as a number.
Investment alpha is useful for investors because it gives them a way to truly understand how their assets are doing. A stock may have positive growth on paper over a certain period, leading an amateur to believe they made a great choice. But if the percentage growth of a comparable index during that time is twice as much, the stock is actually under-performing.
Beta is a measure of an asset’s historical volatility. Investors calculate beta from correlating the past movements of the investment to a particular benchmark.
Often, like with alpha, this benchmark is an index fund. When an asset moves perfectly in-line with an index, the beta is 1. If an asset and index move in precisely opposite directions, the beta would be -1. If a stock’s beta were to exceed 1, it would mean that the stock is more volatile than the market. Less than 1, and the asset historically shows less volatility than the market. A beta of zero means there is no correlation whatsoever.
Let’s say a stock has a beta of 1.25. This would imply that the stock is 25% more volatile than the benchmark in comparison. If in another case a stock has a .5 beta compared to the S&P 500, it would imply it is half as volatile as the index.
When taking on greater risk, investors should expect possible returns that justify the action. High dividend-paying equities or utilities offer less risk, so their betas will often be lower. By contrast, riskier stocks will often have higher betas.
Investors use alpha and beta in regards to the Capital Asset Pricing Model (CAPM). The CAPM measures the correlation between expected returns and risk. This model allows investors to find equilibrium with investments by comparing an asset’s movement sensitivity to the stock market.
Alpha is compared to the expected rate of return given from the CAPM. If an investment beats out the expected return from the model, it has achieved alpha. Beta is used in the formula as one of the many factors that help calculate investment risk.
Ra = Rfr + β (Rm – Rfr)
When it comes to beta, volatility is a double-edged sword. Smart investors understand the potential it offers and look to use it to their advantage. They understand that markets run on volatility, since many investors sell when prices are falling and buy on the upswings. Train yourself to do the opposite.
One way to be an intelligent investor is to look for stocks that have high betas when the market is rising, and low betas if the market is falling. The reason for this is simple. High beta stocks, albeit riskier, have the potential to climb higher than the market. By contrast, lower beta stocks contain less risk than the market, and therefore shouldn’t sink lower than it. When the market does decline, investors using this method look for low beta stocks in order to be extra conservative.
As we said earlier, alpha serves as a way to evaluate how your investments did relative to a benchmark. Investors do however rely on it less than beta. While alpha gives you an idea of how your investments have fared, beta is more concrete in calculating risk (especially through the CAPM). Combining alpha with beta statistics is a great way for investors to assess potential assets going forward.
While useful, alpha and beta aren’t perfect when it comes to calculating risks. The future is impossible to predict, and the past only offers investors clues on how the future will unfold. Some of these clues can be found by utilizing alpha and beta, thus allowing you to make much more educated guesses. Hone your craft by always looking to diminish risk on investments, and your likelihood of success will increase.