What Is the Difference Between Alpha and Beta?
In finance, alpha and beta are two of the most commonly used measurements, to gauge how successful portfolio managers performs, relative to their peers. Simply defined, alpha is the excess return (also known as the active return), an investment or a portfolio of investments ushers in, above and beyond a market index or benchmark that represent the market’s broader movements.
Beta is a measurement of the volatility, or systematic risk of a security or portfolio, compared to the market as a whole. Often referred to as the beta coefficient, beta is a key component in the capital asset pricing mode (CAPM), which calculates the theoretically appropriate required rate of return of an asset, to make it worth incorporating into an investment portfolio.
Although the Alpha figure is often represented as a single number (like 3 or -5), it actually describes a percentage that measuring how a stock of mutual fund performed compared to a benchmark index. The numbers mentioned would mean the investment respectively fared 3% better and 5% worse than the broader market. Therefore, an alpha of 1.0 means the investment outperformed its benchmark index by 1%, while conversely, an alpha of -1.0 means the investment underperformed its benchmark index by 1%.
What Is the Difference Between Alpha and Beta
Alpha is essential to gauging an investment manager’s true success. For example, an 8% return on a mutual fund seems impressive when equity markets as a whole are returning 4%. But that same 8% return would be considered underwhelming if the broader market is earning 15%.
With the CAPM, alpha is the rate of return that exceeds the model's prediction. Investors generally prefer investments with high alpha. For example, if the CAPM analysis indicates that the portfolio should have earned 5%, based on risk, economic conditions and other factors, but instead the portfolio earned just 3%, the alpha of the portfolio would be therefore be a discouraging -2%.
Formula for Alpha:
Alpha=Start PriceEnd Price+Distribution per Share−Start Price
Portfolio managers seek to generate alpha by diversifying portfolios to eliminate unsystematic risk. Because alpha represents the performance of a portfolio relative to a benchmark, it represents the value that a portfolio manager adds or subtracts from a fund's return. The baseline number for alpha is zero, which indicates that the portfolio or fund is tracking perfectly with the benchmark index. In this case, it can be extrapolated that investment manager has neither added or lost any value.
Beta fundamentally analyzes the volatility of an asset or portfolio in relation to the overall market, to help investors determine how much risk they’re willing to take to achieve the return for taking on said risk. The baseline number for beta is one, which indicates that the security's price moves exactly as the market moves. A beta of less than 1 means that the security will be less volatile than the market, while a beta greater than 1 indicates that the security's price will be more volatile than the market. If a stock's beta is 1.5, it is considered to be 50% more volatile than the overall market.
Here are the betas (at the time of writing) for three popular stocks:
We can see that Micron is seen as 26% more volatile than the market, while Coca-Cola is 37% as volatile as the market, and Apple is more in line with the market or 0.01% less volatile than the market.
Betas vary across companies and sectors. For example, while many utility stocks have a beta of less than 1, many high-tech, Nasdaq-listed stocks have a beta of greater than 1. This means that the latter groups of stocks offer the possibility of higher rates of return, but generally pose more risk.
While a positive alpha is always more desirable than a negative alpha, beta isn’t as clear-cut. Risk averse investors such as retirees seeking a steady income are attracted to lower beta. On the other hand, risk-tolerant investors who seek growth, are often willing to invest in higher beta stocks, whose higher volatility often generate superior returns.
Investors must distinguish short-term risks, where beta and price volatility are useful, from long-term risks, where fundamental, big picture risk factors are more prevalent.
Investors looking for low-risk investments might gravitate to low beta stocks, whose prices will not fall quite as much as the overall market drops during downturns. However, those same stocks will not rise as much as the overall market during upswings. Investors can use beta figures to determine their optimal risk-reward ratios for their portfolios.
Formula for Beta
Her is a useful formula for calculating beta:
Beta=Variance of Market’s ReturnCovariance of Asset’s Return with Market’s Return
- Covariance is used to measure the correlation in price moves of two different stocks. Covariance measures how two stocks move in relation to one another. A positive covariance means the stocks tend to move in lockstep, while a negative covariance conveys stocks move in opposite directions.
- On the other hand, variance refers to how far a stock moves relative to its mean, and is frequently used to measure the volatility of an individual stock's price over time.
Both alpha and beta are backward-looking risk ratios and it is important to remember that past performance is no guarantee of future results.
Investors use alpha to measure a portfolio manager's performance against a benchmark while also monitoring the risk or beta associated with the investments that comprise the portfolio. Some investors might look for either a high beta or low beta depending on their risk tolerance and expected rate of return.