Alpha and beta are measures used by investors to evaluate the performance and risk of an investment security or portfolio. They are two different parts of an equation used to explain the performance of stocks and investment funds.
Simply speaking Beta is a measure of market risk, and alpha indicates if the returns of an investment exceed the returns that its beta would predict. The main difference between the two is that alpha is used to identify performance relative to an index, while beta identifies volatility relative to an index.
What is Alpha?
Alpha is a financial metric used in investing to determine whether an asset (such as a stock or mutual fund) outperformed a comparable benchmark, based on its level of risk. This is referred to as “excess return.”
The baseline value of alpha is 0. An alpha value positive 1 (+1) shows that the return on the investment during a specified time frame outperformed the overall market average by 1 %. A negative alpha number reflects an investment that is underperforming as compared to the market average. An alpha of zero means that the investment earned a return that matched the overall market return, as reflected by the selected benchmark index.
The goal of alpha investing is to beat the market by investing in high-performing assets. For example, investors can use this metric to identify whether their investment will be able to outperform the market index S&P 500. Understanding this financial metric is also very important. It helps investors decide whether the return on their investment is high enough to outweigh investment fees.
How is Alpha calculated?
The formula for Alpha is as follows:
Alpha = R – Rf – beta (Rm-Rf)
Where:
- R represents the portfolio return
- Rf represents the risk-free rate of return
- Beta represents the systematic risk of a portfolio
- Rm represents the market return, per a benchmark
Let’s take an example.
The actual return of the fund is 30.
The risk-free rate is 8 %.
Beta is 1.1
The benchmark index return is 20%,
Alpha is calculated as:
Alpha = (0.30-0.08) – 1.1 (0.20-0.08)
= 0.088 or 8.8%
The result shows that the investment in this example outperformed the benchmark index by 8.8%.
Read:
- Forex vs stocks
- Top infrastructure stocks
- Best 3D printing stocks
- Buzzing stocks
- Top trending stocks
- Best AI backed stocks
Pros and Cons of Alpha
| Pros | Cons |
| Measures excess returns compared to a benchmark index | Measures past performance and does not guarantee future returns |
| Helps you determine whether your fund manager is adding value | Needs to be measured over long periods to be as accurate as possible |
One of the major benefits of Alpha is that it clearly defines whether the investment you are choosing adds value to your portfolio or not. This is done by defining whether the investment is yielding higher than the market index return or not.
On the other hand, alpha is a measure of past performance, so you cannot predict how your investment will perform in the future based on this data alone.
Checkout:
- Accurate and Reliable Gold Forecast
- Reliable and Trusted Commodity Signals
- Reliable forex signals
Why Choose Alpha?
Alpha measures the risk-adjusted performance of a particular stock or mutual fund. In other words, it considers the volatility of a security’s returns relative to the market. This makes Alpha a more accurate measure of investment performance than simple returns alone.
Main reasons why investors choose Alpha:
- Alpha measures how much an asset has outperformed a benchmark
- Alpha can be a simple calculation or can factor in risk-adjusted returns
- Alpha considers risk and Beta (volatility)
- Alpha can be used to measure the performance of entire portfolios
Also read:
- Best day trading stocks
- Best stock advisor service
- Best forex indicators
- Best preferred stocks
- Best penny stocks to invest in
- Best crypto day trading strategies
How to Use Alpha for Investing?
There are several ways to use Alpha when making investment decisions.
The first way investors can make use of Alpha is as a measure of risk-adjusted returns. This helps them identify stocks or mutual funds that have the potential to generate higher returns than their benchmark indexes after taking into account risk factors.
Another way to use Alpha is to compare the performance of different stocks or mutual funds within the same asset class. The stock or mutual fund which gives a higher Alpha is a better performer.
Lastly, Alpha can be used as a good tool for a good investment strategy. It helps investors decide which investment option is more profitable and likely to generate higher returns.
A stock or mutual fund with a high alpha has the potential for higher returns. However, investors have to be careful when investing in securities with high alpha values because these securities are more volatile than the market as a whole.
Limitations of Alpha
Alpha comes with a few limitations that should also be clearly understood when investors choose to use this tool. One of these limitations relates to various types of funds. Meaning investors might use this metric to evaluate different asset classes. The diverse nature of the different funds will affect the value of alpha and can be misleading to compare and analyze.
Alpha works best, first of all, when applied to strictly stock market investments. Also when using this tool to decide and analyze it’s always best to compare the value of Alpha for similar funds.
For example, compare the Alpha values of different Mutual Funds which include all large-cap companies instead of comparing a Mutual Fund with large-cap companies with a Mutual Fund carrying small-cap companies.
Another important consideration for investors while using this metric is choosing a benchmark index. The alpha value is calculated and compared to a benchmark that matches the portfolio it is being compared with. Investors should select a relevant benchmark. The most frequently used benchmark index is the S&P 500 stock index.
However, not all portfolios are relevant enough to compare to the S&P 500 index. Some portfolios, such as sector funds, might not give a valid comparison when compared with S&P 500 index. Therefore, in this case, a different index is required.
What is Beta?
Beta—also known as the beta coefficient—is a measure of an investment’s historical volatility compared to a market index (usually, the S&P 500). In other words, beta tells you how risky an investment is.
Analyzing beta can help investors build a balanced portfolio. A common use for beta is measuring whether an asset is suitable for the portfolio’s risk tolerance since beta investors often focus on systematic investment risks like volatility.
A company with a higher beta has greater risk and also greater expected returns. The beta coefficient can be interpreted as follows:
- β =1 exactly as volatile as the market. While there’s systematic risk in beta 1.0, beta calculation won’t detect unsystematic risk.
- β >1 is more volatile than the market. A beta value of 1.4 would indicate that the volatility of the stock is 40 % higher than the market. Adding this stock to your portfolio will cause risk to increase. But the expected return will increase, as well.
- β <1>0 less volatile than the market. If the market goes up by 10 %, the stock might only go up by 5 %. Moreover, this means security is not as volatile as the market. So by adding stock with this beta value, investors are making their portfolio less risky.
- β =0 uncorrelated to the market. The stock has no relevance to how the market moves.
- β <0 negatively correlated to the market. It means that the stock tends to move in the opposite direction of the market. For example, if the market is going up, the stock might go down.
Checkout:
- Best crypto signals
- Best undervalued stocks
- Best stock indicators
- Top trading blogs
- Best regional bank stocks
How is Beta Calculated?
Here is the formula for Beta:
Beta = Covariance( Re, Rm)Variance(Rm)
Where,
He is the individual stock’s return
Rm is the overall market return
Covariance – How the changes in the return of the stock relate to changes in the return of the market
Variance – How far the market data points spread out from the value’s average
Pros and Cons of Beta
Beta can be a helpful tool for investors, but it’s important to remember that it has its limitations.
Some advantages of beta include:
- It’s a simple measure that can be easily calculated.
- It can compare the risk of different stocks.
- It takes into account the overall market conditions.
Some disadvantages of beta include:
- It’s a historical measure, which means it only tells us how a stock has behaved in the past.
- It doesn’t take into account the size of the movements, just how often they occur.
- It’s just one factor to consider when assessing risk. Other factors, such as the size of the company, the industry it operates in, and overall market conditions can also affect risk.
Risk Assessment in Beta
Beta is used as a measure of risk. A high-beta stock is riskier than a low-beta stock.
However, it’s important to remember that beta is only one factor to consider when assessing risk. Other factors, such as the size of the company, the industry it operates in, and overall market conditions, can also affect risk. When assessing risk, it’s important to consider all of the factors involved and not just beta.
Also, read:
How to Use Beta in Investing?
Beta is a very helpful tool for your investment strategy.
Security with a beta lower than one means less volatile investment. And securities with higher than one value means more volatile than the market.
Beta helps when trying to choose between two investments. For example, if you are looking at two stocks with the same expected return, but one has a higher beta than the other, the stock with the lower beta will be a good choice. This is because the stock with the lower beta will be less volatile than the stock with the higher beta.
Differences Between Alpha and Beta
The differences between alpha and beta are primarily between what they measure, or what they tell investors.
| Sr. | Difference | Alpha | Beta |
| 1 | What it measures | Measures investment performance | Measures the volatility of an investment |
| 2 | How it helps investors | Helps you identify the best-performing investment funds | Helps you identify an asset’s volatility |
| 3 | Baseline Value | 0 | 1 |
Checkout:
- Best drone stocks
- Forex Signals providers
- Best NFT stocks
- Best swing trading stocks
- Technical analysis books
- What it measures – Alpha measures performance relative to a benchmark index and beta measures the volatility of an investment relative to a benchmark index.
- How it helps investors – Alpha and beta can both be used to help decide whether or not to buy an investment. They can be used independently or they may be used together to determine if an investment is expected to outperform a benchmark index, adjusted for its risk.
- Baseline measures: The baseline measure for alpha is zero, meaning that an investment’s performance does not exceed its relative benchmark. The baseline measure for beta is 1.0, meaning that an investment’s price movement (volatility) is the same as the benchmark index.
The two metrics are similar in that they can help investors make decisions about what investments to buy or not buy.
Key Points to Consider for Alpha and Beta
- Alpha is always positive, while Beta can be positive or negative.
- Alpha reflects the possibility of high stock price performance, while Beta reflects the volatility of a security.
- Alpha is used to calculate risk-adjusted returns, while Beta is not.
- Beta is more popular than Alpha because it is easier to calculate.
- Alpha should not be used as the only measure of a security’s risk or volatility.
- Alpha and Beta are important indicators for investors to consider when making investment decisions.
- Most stock software contains Beta calculations but not Alpha.
CONCLUSION
Alpha is important to consider especially when the investor is actively managing his portfolio or considering investing in an actively managed fund. A higher alpha is always better, as it means a greater return on investment. But investors need to make sure they are using an appropriate benchmark, also consider the fund’s fees, and make sure that the return of the fund is not due to increased risk.
Beta measures volatility and is used to assess risk. It’s important to remember that beta is only one factor to consider when assessing risk. Investors need to employ other methods to gain the best picture of a stock.
Investors make use of this financial metric in order to increase their portfolio values. Therefore, assistance from an investment manager will help. when evaluating potential investments, it’s best to consider both the alpha and beta, along with other factors, and not just depend on any single metric to make your decisions.
Also, learn:
- Top domestic stocks
- Best covered call stocks
- Best drip stocks
- Best stock signals
- Best stock forecast website
- Stocks vs Shares
