Alpha and Beta: What is the Difference for Investors?
Alpha and beta are two key risk ratios used to evaluate the performance of an investment asset. 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 measures the return on an investment in comparison to the market index or other broad benchmark. For example, alpha might be the rate a recently purchased stock grew or diminished compared to the S&P 500 Index. If their investment’s growth outpaced the S&P 500, one would say it has achieved “alpha.”
Beta measures the relative volatility of an investment compared to the market as a whole. Before investing, beta would tell an investor how well a potential investment mirrored the S&P 500 over its existence. These two concepts are useful tools for every investor looking to make informed investment decisions.
What is Alpha for Investors?
Alpha measures the return on an investment compared to a market index or benchmark. Specifically, alpha indicates the percentage below or above a benchmark index the stock achieved, but is represented as a single number. For example, if a stock performs 3% better than the S&P 500, the alpha of that stock would be 3. The baseline number for alpha is zero, meaning the portfolio or stock is tracking perfectly with the benchmark index. Alpha is a historic measure, a positive alpha means the fund has historically outperformed the index, and a negative alpha means the fund has historically underperformed the index.
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, which when looked at out of context can lead an investor to believe it has performed well. But if the percentage growth of a comparable index during that time is twice as much, the stock is actually under-performing. Alpha is most often used to compare mutual funds.
What is Beta for Investors?
Beta measures the volatility of a stock, fund, or portfolio in comparison with the market as a whole. Like with alpha, a benchmark index (most commonly the S&P 500 Index) is used as a proxy measurement for the overall market. Calculating the volatility of a stock’s price can be useful for an investor to decide whether an investment is worth the risk.
The baseline for beta is one, which indicates that the security’s price moved exactly with the moves of the overall market. A beta of below 1 indicates lower volatility compared to the market, while a beta greater than 1 indicates more volatility than the market.
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 0.5 beta compared to the S&P 500, it would imply it is half as volatile as the index.
A higher beta indicates a riskier investment with the potential of excess returns, while a lower beta indicates a more conservative investment with lower expected returns.
What’s the Difference Between Alpha and Beta?
|Measures investment performance (Changes in Price)||Measures the volatility of an investment|
|Helps identify best performing stocks and investment funds||Helps identify an asset’s volatility|
Understanding the Capital Asset Pricing Model (CAPM)
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)
- Ra = Expected rate of return – the profit or loss anticipated on an investment. The expected rate of return is calculated by taking potential returns and multiplying them by the probability of their likelihood.
- Rfr = Risk-free rate – rate of return if an investment carried zero risk. This theoretical rate gives investors an estimate on what a “risk-free” investment might look like over a certain period of time. For example, treasury bonds are considered very low risk. In many cases, they are used as a risk-free rate since there aren’t many other investments that have less risk. If a treasury bond were to return 3% over a ten-year period, the risk-free rate would be 3%.
- β = Beta – measures the volatility of potential returns. Derived from calculating the asset’s sensitivity to a market’s movements.
- Rm = Expected return of the market – the percentage returns the market is anticipated to attain. If the stock market is expected to go up 8% over the next ten years, the expected rate of return would be 8%.
How do Investors use Alpha and Beta?
Alpha and beta are both measurements used by investors and portfolio managers to compare the performance and volatility of an underlying security. These tools are useful for investors when aligning their investments with their risk tolerance. When using alpha and beta, keep in mind that the measurements are based on historic data and do not indicate the future movement of a stock or mutual fund. Alpha and beta are generally used alongside additional ratios or measurements to select investments that meet your objective.
Alpha: Generate Excess Returns
Alpha is often the stated goal of active portfolio managers. Active managers seek to generate alpha in diversified portfolios. Because alpha measures performance above or below a benchmark, it represents the return on investment that is not a result of a general movement in the greater market. For this reason, alpha is often used to compare portfolio managers performance when choosing mutual funds to invest in.
Beta: Calculate Risk
While alpha gives you an idea of how your investments have fared, beta is more concrete in calculating risk (especially through the CAPM). One common investment strategy using beta is to look for stocks that have high betas when the market is rising, and low betas if the market is falling. The reason being that 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 will generally look for low beta stocks in order to be extra conservative.
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.