Alpha and Beta for Beginners By Jesse Emspak | September 21, 2015 — 10:35 AM EDT
We often hear the terms alpha and beta when talking about investments. Both of these are numbers that measure related but different things.
Alpha is a number assigned to the return over a given index. So if you invest in a stock and it returns 20% while the S&P 500 earned 5%, then you have an alpha of 15. A -15 means that your investment under performed by 20%. Alpha is also a measure of risk. In the above example the -15 means the investment was far too risky given the return. An alpha of zero is “just right” – one has earned a return commensurate with the risk. Alpha of greater than zero means an investment outperformed. (For more, see: Bettering Your Portfolio With Alpha and Beta.)
When hedge fund managers talk about high alpha, they’re usually saying that their managers are good enough to outperform the market. But that raises another important question: if alpha is an “excess” return over an index, exactly what index are you using? For example, a fund manager might say that she or he got a 20% return when the S&P brought in 15%, an alpha of 5. But was the S&P an appropriate index to use? Consider a manager who put all of a client’s money into Apple Inc. (AAPL
) stock on Aug. 1, 2014. Compared to the S&P 500 the alpha would look quite good: Apple returned 18.14% while the S&P 500 returned 6.13%, for an alpha of about 12.
But it’s unlikely that most experts would consider the S&P a proper comparison for Apple all by itself, given the differing levels of risk. Perhaps the NASDAQ would be a more appropriate measure. The NASDAQ in that same yearlong period returned 15.51%, which pulls the alpha of that Apple investment down 2.63. So when judging whether a portfolio has a high alpha or not, it’s useful to ask just what the baseline portfolio is. (For more, see: Adding Alpha Without Adding Risk.)
This relates to beta. Unlike alpha, which measures relative return, beta is the measure of relative volatility. If you put all your money in every possible investment then your beta is 1. A tech stock in this case would have a beta above 1 (and probably rather high), while a T-bill would be close to zero, because their prices hardly move relative to the market as a whole.
Beta is a multiplication factor. A stock with a beta of 2 relative to the S&P 500 goes up or down twice as much as the index in a given period of time. If the beta is -2 then the stock moves in the opposite direction from the index, by a factor of two. Some investments with negative betas are inverse exchange-traded funds (ETFs) or some types of bonds. (For more, see: Beta: Know the Risk.)
What beta also tells you is the risk that you can’t get rid of by diversifying. If you look at the beta of a typical mutual fund it’s essentially telling you how much risk you’re adding to a portfolio of funds.
Again similar caveats to alpha apply: it’s important to know just what you’re using as your benchmark for volatility. Morningstar, Inc. (MORN
), for example, uses U.S. Treasuries as its benchmark for beta calculations. The firm takes the return of a fund over T-bills and compares that to the return over the markets as a whole and using those two numbers comes up with a beta. There are, though, a number of other benchmarks one could use. (For more, see: Beta: Gauging Price Fluctuations.)
The Bottom Line
Alpha and beta are both risk ratios that investors use as a tool to calculate, compare and predict returns. They’re very important numbers to know, but one must check carefully to see how they are calculated. (For more, see: A Deeper Look at Alpha.)
Read more: Alpha and Beta for Beginners | Investopedia http://www.investopedia.com/articles/investing/092115/alpha-and-beta-beginners.asp#ixzz4iP0bxSzc
Follow us: Investopedia on Facebook