Alpha and beta are two statistical measurements used in modern portfolio theory (MPT) to help investors determine the risk-return profile of an investment. Both are measures of past performance, and its important to keep in mind that historical data doesnt guarantee future returns. Still, these measurementsalong with other datacan help you select which investments to add to your portfolio.
Alpha vs. beta in investing
Alpha represents how much an investments actual return exceeded its expected return, based on its risk level. Alpha is used to evaluate whether an investment outperformed a certain benchmark.
Beta, on the other hand, measures how volatile an asset is compared to the overall market. Essentially, it calculates the risk level of an investment.
What is alpha?
Alpha is a measure 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.
Alpha can be used to evaluate a fund managers performance or ability to outperform a market index, such as the S&P 500. Understanding the alpha can also help you decide whether the return you hope to earn will be high enough to outweigh any potential investment fees, such as the expense ratio. Overall, the goal of alpha investing is to beat the market by investing in high-performing assets.
How alpha is calculated
Alpha is calculated by subtracting the benchmark return from an assets return.
Alpha = Asset return - Benchmark return
For instance, lets say a mutual fund returned 8% over one year, while the S&P 500 returned 6%. Since the annual return for the mutual fund was greater than that of the S&P 500, the fund has an alpha of 2% (8% - 6%).
On the flip side, if the S&P 500 had a return greater than 8%, the fund would have a negative alpha. If the two returns were equal, the alpha would be zero, which is also known as the baseline.
In general, a higher alpha is more desirable for investors since it means greater return on investment. A lower alpha indicates the fund earned below the average expected for its risk level.
Pros and cons of alpha
One of the benefits of measuring alpha is the ability to critically examine whether a fund manager is adding value to your investment. 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.
Pros
- Measures excess returns compared to a benchmark index
- Helps you determine whether your fund manager is adding value
Cons
- Measures past performance and does not guarantee future returns
- Needs to be measured over long periods to be as accurate as possible
What is beta?
Betaalso known as the beta coefficientis a measure of an investments historical volatility compared to a market index (usually, the S&P 500). In other words, beta tells you how risky an investment is.
The market index as a whole has a beta of 1. So an asset with a beta of more than 1 is considered to be more volatile than that index, while an asset with a beta of less than 1 is less volatile. And an asset with a beta of 1 would be expected to move in sync with the index. Some assets have a negative beta, including put options.
Analyzing beta can help you build a balanced portfolio. A common use for beta is measuring whether an asset is suitable for your risk tolerance, since beta investors often focus on systematic investment risk like volatility, says Chris Faber, portfolio manager at asset management firm RMB Capital.
How beta is calculated
The formula to calculate beta is slightly more complex. Beta is calculated by dividing the covariance of the assets return and the markets return by the variance of the market.
Beta = Covariance / Variance
In this case, covariance refers to the direction of the relationship between the asset and market return. If both are moving in the same direction, the covariance is positive. But if they are moving in the opposite direction of each other, the covariance is negative. On the other hand, variance refers to the degree of risk in the overall market.
Thankfully, most financial websites that publish stock quotes will include an assets beta so you dont have to calculate it by hand.
Heres an example: Lets say you want to purchase shares of a stock with a beta of 1.5. This means that the stock carries 50% more risk than the overall market. If you are a risk-averse investor, you may determine that this investment is above your tolerance and avoid it altogether. But if you are aiming to achieve a higher return, you may opt for the higher-risk investment with the hope that it produces higher returns.
Pros and cons of beta
Measuring beta can be helpful for evaluating whether an investment carries enough or too much risk to add to your portfolio. However, beta is not as useful in the long run since an assets value may fluctuate drastically from one year to the next.
Pros
- Measures your investments risk level against the market
- Helps you determine whether an investment matches your risk tolerance
Cons
- Measures past performance and does not guarantee future returns
- Less effective over long periods since the risk level of an asset can change drastically over the years
How to choose between the two when measuring risk
Whether investors hope to increase their gains based on alpha or beta investing, its important to work with an investment manager who has experience working with that specific risk, says Faber.
However, when evaluating potential investments, its best to consider both the alpha and beta, along with a host of other factors, and not just either/or. Remember that alpha and beta are both backward-looking data points, which cannot be used as evidence of future performance.
