What is Alpha & Beta?
Financial Education Series
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One of the most important principles to learn in fundamental analysis as a retail investor is beta and alpha. These two numbers alone can describe a particular stock or portfolio in an effort to allow you to create the correct risk reward scenario for you or determine the skill of a fund manager.
Let’s start with the Beta coefficient, or commonly referred to as just Beta.
Beta
Beta is used to measure the variability between a particular security or portfolio’s movement in comparison with the market in general. In this definition, variability is “the extent to which data points in a statistical distribution or data set diverge—vary—from the average value, as well as the extent to which these data points differ from each other” (Investopedia).
As I have stated before, the S&P 500 is usually the “overall market” when being compared. For example, if a stock has a beta of 1.00 it would generally move in unison with $SPY (SPDR S&P 500 ETF Trust). A stock that has a higher beta than 1.00 (1.50 for example) the security will be more volatile than the comparable index and if the beta is less than 1.00 (.60 for example) it will be much less volatile. Beta can also be negative. This would describe a security that is a hedge against the overall market. If the beta is -1.4 for example and the market moves up 10% your security might see a decline of 14%. For individuals who are looking for conservative investments (generally retirees) they would want a lower beta for risk aversion. Obviously the opposite for individuals looking for explosive growth and are willing to encounter higher risk an individual would want to seek a higher beta.
Alpha
Alpha alpha alpha… For most portfolio managers this is essentially the end all be all. Often times alpha is simply referred to as returns higher than an index. For instance if you had 2% alpha for the quarter and the S&P 500 performed 5% that means you actually had a total % return of 7% overall. However, like most finance definitions there are stricter translations that can host much more information regarding alpha. Alpha in the stricter sense (known as Jensen’s Alpha), is number that also includes a risk adjusted component to its calculation. Positive alpha means that investment performance was higher than the comparable benchmark index performance after factoring in the risk taken in terms of volatility. The most common formula for computing this type of alpha for a portfolio goes like this:
(total portfolio return - risk-free rate) - (portfolio beta x [market return-risk - free rate])
In this calculation the performance is being compared with the given index after eliminating the risk-free rate.
At a glance, Beta and Alpha can be very helpful in picking the right fund or security but sometimes it can be misleading and not tell the whole picture. For instance, it would be ridiculous to brag about the performance of a portfolio that is comprised of small cap tech stocks in comparison to the S&P 500 index. Make sure that beta and alpha usage is for the correct comparable index.
Hopefully this clears up any confusion on beta and alpha if you had any in the first place!
-REBEL
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