The Difference Between Alpha and Beta

If you are truly serious about becoming a successful investor, you need to find a way to measure the risks you are taking and the returns you are making. All of the best portfolio managers in the world are experts at calculating and understanding these critical measurements. Without a way to gauge investment performance and risk, you won’t be able to make educated decisions that help you achieve continuous investment success.

Two of the most common measurements that are used to measure risk and investment performance in the finance world are alpha and beta. These two terms can help you figure out systematic risk, investment potential, and much more. If you aren’t familiar with alpha and beta or simply want to refresh your memory on how they can be used to your advantage, this article is for you. Below, we will be learning about the difference between alpha and beta.

Alpha – How is an asset performing?

Whenever we take a look at an investment, we need to understand how to measure its performance. One of the most basic ways to think about investment performance is with return on investment, which is often calculated with percentage points. However, what do we do when we want to calculate a return that includes the assumption of volatility risk? That is where alpha comes into play.

Alpha is the calculation of excess return on an investment that is above a market index or benchmark. The S&P 500 is one of the most common benchmarks used to calculate alpha for U.S. stock funds. If an investment performs better than the benchmark, it will have a positive alpha. If an investment performs worse than the benchmark, a negative alpha value is generated.

Alpha is a historical measure that really tells us how well a stock or portfolio is doing. For example, if you invested in a stock that has gained 7% over the past year, you might think that it was a great decision. However, if the overall market gained 15% over the past year, your investment actually was not that great. This is why understanding alpha is so important.

When alpha has a value of zero, it means that the investment earned the exact return that was appropriate for the amount of risk assumed. When alpha is above zero, it means that the investment earned a return that compensated more than the volatility risk. Generally speaking, the higher the alpha, the better the investment. Alphas of less than zero signify that the investment earned a return that was not worth the volatility risk that was assumed.

Beta – How much volatility?

Another important measurement to understand in order to become a successful investor is beta. Beta is the historical measure of volatility and it helps us learn how assets move when compared to a benchmark such as an index. You can think of volatility as the systematic risk of a security. You wouldn’t want to invest in something that is riskier than the overall market without being compensated for it. This is one of the fundamental reasons why beta is so important to investors.

Beta typically uses a baseline value of 1 to help investors gauge the risk of an investment. If a security has a beta of 1, that means that the price will move exactly as the baseline moves. If a security has a beta of 1.5, that means it is considered to be 50% more volatile than the baseline.

A high beta doesn’t necessarily mean that the security is bad. It really just helps us understand the risk of an investment to a greater extent. If you are looking for a lower risk portfolio, you would probably be more drawn to assets that have lower betas. Investors that are interested in generating the highest returns possible will have to take on more risk with higher beta securities. It all depends on your risk tolerance.

As you can tell, alpha and beta are great tools for helping us make more accurate investment decisions. When we combine both of these historical measures together, we can gain a better understanding of what fits in with our own investment style and goals. Alpha and beta are not perfect, particularly since they are backward-looking. That means you can’t always rely on them to be an indication of future results. With that being said, you should absolutely use these measurements to your advantage over the long term now that you have a better idea of what they mean.