In my twenty-plus years of following investments, working as a financial advisor and writer, two terms that come up frequently are alpha and beta. The reason why is because they are a great way to measure an investment. Alpha and Beta are two of the five ways to measure the performance of an investment. They are commonly used together because they measure two opposite characteristics. The other measurements are the Sharpe ratio, R-squared, and standard deviation.
If you are new to investment research, these terms may seem foreign or very technical. I assure you, that by the time you read the end of this article, you will understand the meaning of alpha and beta in fiance and also understand the calculations.
So what are alpha and beta? The short answer is that alpha and beta are two key historical standards to measure risk in a stock, a mutual fund, an investment portfolio, or a stock’s performance. Alpha is used to measure the amount of return of an investment compared to the market index or benchmark. Beta, on the other, evaluates the volatility of an investment. Beta is commonly used to analyze the relative risk of an investment.
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What are the Differences Between Alpha and Beta Scores?
Alpha is the historical evaluation of an asset’s return on investment (ROI) compared to expect return after adjusting to the risk associated with that asset. Meanwhile, beta is the historical evaluation of volatility and calculates how an asset (stock, mutual fund, investment portfolio, ETF) performs against an index or a benchmark.
Investors often ask, is alpha or beta more important? For most investors, both are important. Obviously the higher alpha, the better. However, a high beta score may highlight positive performance in growth stocks but may not be preferable by investors seeking steady returns and low risk. Most successful investment strategies require the management of risk in relation to the investment objective. Investing in a stock solely because it has a high alpha could cause you to lose your investment loses value suddenly.
The chart above shows Exxon Mobil stock (XOM) from 1967 to the present with both positive and negatives alpha. Historically XOM has been a positive alpha stock, but the recent drop in oil prices has caused the alpha to turn negative. Had you invested from 2004 to 2017, Exxon Mobil would have been a great investment (I still think it is good to stock). The lesson here is that both the alpha and beta of investment change over time.
What is the Alpha Calculation For Stocks and Investment Portfolios?
Alpha is used to determine an asset’s performance on a risk-adjusted basis. The purpose here is to find out whether an investor is being rewarded for the risk taken. At times, the ROI may be better than benchmarks or indexes, but that alone might not be sufficient to compensate for the volatility risk fully. The alpha figure for stocks is denoted by a single number such as ‘1.0’ or ‘-3.0’. However, the number is expressed as a percentage of above or below stock or fund achieved in an index or benchmark.
In this case, the alpha score of ‘1.0’ means a particular stock or fund outperformed its benchmark index by 1%. Meanwhile, an alpha score of ‘-3.0’ means that the asset or stock underperformed its benchmark index by 3%. If the alpha is zero, it means the investment is aligned with the benchmark.
Note that alpha is a historical figure. It’s only useful to monitor and evaluate how a stock or investment performs over time. Still, it doesn’t offer any useful forecasts of how it will perform the next day or week.
What is the Beta Alpha Calculation For Stocks and Investment Portfolios?
Beta, also known as the beta coefficient, measures how volatile a specific asset, fund, stock, or stock portfolio is in a given market. The beta figure indicates the price volatility of security and is advantageous for investors when deciding whether trading that stock is worth the risk.
The baseline beta is 1.0. A stock or fund beta below 1.0 means that this particular stock is.
volatile than the overall market, whilst a beta higher than 1.0 signifies that the security price is more volatile than the broad market. Meanwhile, if a security or fund’s beta is 1.3, it means that its price is 50% more volatile than the market as a whole.
Amazon Stock (AMZN) has a 1 year beta of 0.4866 while Exxon Mobil has a 1 year beta of 1.1294. Both are good stocks, but Exxon Mobil has been recently dropped. In the
Like alpha, the beta is a historical figure, and historical numbers are notorious for not providing substantial or empirical data on future returns.