Alpha is used in finance as a measure of performance. Alpha, often considered the active return on an investment, gauges the performance of an investment against a market index or benchmark which is considered to represent the market’s movement as a whole. The excess return of an investment relative to the return of a benchmark index is the investment’s alpha.
Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. Beta is used in the capital asset pricing model (CAPM), which calculates the expected return of an asset based on its beta and expected market returns. Beta is also known as the beta coefficient.
Alpha and beta are used together by investment managers to calculate, compare, and analyze returns. They are two of the five standard technical risk calculations, the other three being the standard deviation, R-squared, and the Sharpe ratio.
Alpha is perceived as a measurement of a portfolio manager's performance. Alpha is used for mutual funds and all types of investments. It's often represented as a single number (like 3 or -5), but this refers to a percentage measuring how the portfolio or fund performed compared to a benchmark index (i.e., 3% better or 5% worse).
In short, an alpha of 1.0 means the mutual fund or investment outperformed its benchmark index by 1 percent. Conversely, an alpha of -1.0 means the mutual fund or investment underperformed its benchmark index by 1%.
What Is the Difference Between Alpha and Beta
For example, an 8% return on a mutual fund is impressive when equity markets as a whole are returning 4%, but it's far less impressive when the broader market is earning 15%. Alpha takes into account the overall market's performance to give investors a more accurate picture of an investment's performance.
If a capital asset pricing model (CAPM) analysis indicates that the portfolio should have earned 5% (based on risk, economic conditions, and other factors), but instead earned only 3%, then the alpha of the portfolio would be -2%. In CAPM, alpha is the rate of return that exceeds what the model predicted. Investors generally prefer an investment with a high alpha.
Formula for Alpha:
By comparing an investment to a benchmark's performance, we can determine how much the portfolio manager has added to the investment's return. In short, alpha is the return on an investment that is not a result of general movement in the greater market.
Portfolio managers seek to generate alpha in diversified portfolios with diversification intended 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 to or subtracts from a fund's return. As such, an alpha of zero would indicate that the portfolio or fund is tracking perfectly with the benchmark index and that the manager has not added or lost any value.
Beta is a measure used in fundamental analysis to determine the volatility of an asset or portfolio in relation to the overall market. Beta is often used as a risk-reward measure meaning it helps investors determine how much risk their willing to take to achieve the return for taking on that risk. A stock's price variability is important to consider when assessing risk. If you think of risk as the possibility of a stock losing its value, beta has appeal as a proxy for risk.
The baseline number for alpha is zero (investment performed exactly to market expectations), but the baseline number for beta is one. A beta of one is an indication 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.
A beta of 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's determined to be 50% more volatile than the overall market.
Here are the betas (at the time of this writing) for three popular stocks:
We can see that Micron is seen as 75% more volatile than the market, while Coca-Cola is almost 50% less volatile than the market, and Apple is more in line with the market or roughly 10% more volatile than the market.
Betas vary across companies and sectors. Many utility stocks, for example, have a beta of less than 1. Conversely, most high-tech, Nasdaq-based stocks have a beta of greater than 1, offering the possibility of a higher rate of return, but also posing more risk.
While a positive alpha is always more desirable than a negative one, beta, on the other hand, is not as clear-cut. Some investors are risk-averse and prefer to have less risk in their portfolio or a lower beta, for example retirees seeking a steady income. Other more risk-tolerant investors seek growth and are willing to invest in stocks with a higher beta with the aim of achieving higher returns due to the higher volatility.
It's important that investors distinguish between the short-term risks, where beta and price volatility are useful, and the long-term risks, where fundamental (big picture) risk factors are more prevalent.
Investors looking for low-risk investments might gravitate to low beta stocks, meaning their prices won't fall as much as the overall market during downturns. However, those same stocks won't rise as much as the overall market during upswings. By calculating and comparing betas, investors can determine their optimal risk-reward ratio for their portfolio.
Formula for Beta
Although most investment sites like Investopedia.com have beta calculated for you, below is the formula for calculating beta:
- Covariance measures how two stocks move together. A positive covariance means the stocks tend to move together when their prices go up or down. A negative covariance means the stocks move opposite of each other.
- Variance, on the other hand, refers to how far a stock moves relative to its mean. For example, variance is used in measuring the volatility of an individual stock's price over time. Covariance is used to measure the correlation in price moves of two different stocks.
Both alpha and beta are backward-looking risk ratios, and it's important to remember that past performance is no guarantee of future results.
Investors can use alpha to measure a portfolio manager's performance against a benchmark while also monitor 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.