Alpha and beta are two terms that are frequently used in the investment world. They appear complicated, yet they are a lot simpler than they appear. Here’s what you need to know about investing’s alpha and beta, as well as the distinction between the two phrases.
What exactly is alpha in investing?
The return on an investment that exceeds what would be expected based on its level of risk is measured as alpha. It’s also used to determine whether an asset outperformed an applicable benchmark, such as whether an actively managed mutual fund outperformed an index like the S&P 500.
How to Determine Alpha
Alpha is also known as a measure of outperformance because it represents the difference between what asset returns and what its benchmark returns. For example, if a stock fund returns 12% and the S&P 500 returns 10%, the alpha is 2%.
However, alpha should be used to quantify returns that exceed what would be expected for a given degree of risk. If the fund management outperforms an index, it might be because the fund took on more risk than the index.
Beta, which quantifies the volatility of an asset and can be used to assess risk, can be used to calculate expected return. If a company has a beta of 1.2, it may be deemed 20% riskier than the benchmark and, as a result, investors should expect a greater projected return. The stock should return 12% if the index returns 10%. If the stock instead returned 14%, the extra 2% would be deemed alpha.
Alpha examples
Alpha is most commonly employed in the fund sector to assess the skill of a portfolio manager. Active fund managers strive to generate alpha by achieving returns above what would be expected for a given degree of risk-taking.
Alpha can be generated by a fund manager over any time horizon, but it is most valuable when it is developed consistently over long periods of time. Berkshire Hathaway (BRK.B) has outperformed the S&P 500 by about 10% every year since 1965. This indicates that a $1,000 investment in the S&P 500 in 1965 would be worth approximately $296,000 by the end of 2021, whereas the same investment in Berkshire would be worth more than $34 million. That’s quite a bit of alpha.
What exactly is beta in the context of investing?
Beta, often known as the beta coefficient, is a risk indicator that gauges volatility relative to the market. Because the market always has a beta of one, betas greater than one is considered more volatile than the market, while betas less than one are considered less volatile.
How to Determine Beta
Beta is computed by dividing the covariance between an asset’s return and the market’s return by the market’s variance. Because beta is calculated using previous data, the measure is backward looking. Beta may or may not be a useful measure in the future.
You won’t have to calculate the beta for each stock you’re considering. Any stock’s beta can be accessed on the majority of famous financial websites or through your online broker.
Beta examples
Here are three popular stocks, along with their betas as of November 4, 2022.
Each of those assets may pique the interest of various investors for a variety of reasons. A passive investor seeking the market return may choose the Vanguard index fund, whilst a more active investor willing to accept higher levels of risk may choose Tesla. Walmart may appeal to conservative investors seeking stability because of its low projected volatility.
The distinctions between alpha and beta
Though they are both Greek letters, alpha and beta are very distinct. Alpha is a measure of excess return, whereas beta is a measure of an asset’s volatility or risk.
Beta is also known as the return you can receive by passively owning the market. Investing in a benchmark index fund will not result in alpha.
In conclusion
While alpha and beta may appear to be complex and intimidating financial terms, they are simply methods of measuring risk and return. While both indicators should be evaluated before making an investment, keep in mind that they are backward-looking. Historical alpha does not guarantee future results, and an asset’s volatility can vary from day to day.
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