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Alpha and beta are two terms that get thrown around a lot in investing. They sound complicated, but they’re actually much simpler than they seem. Here’s what you need to know about alpha and beta in investing and the difference between the two terms.
What is alpha in investing?
Alpha measures the return on an investment above what would be expected based on its level of risk. It’s also sometimes used as a simple measure of whether an asset outperformed an appropriate benchmark such as whether an actively managed mutual fund outperformed an index such as the S&P 500.
How to calculate alpha
Alpha is sometimes casually referred to as a measure of outperformance, meaning the alpha is the difference between what an asset returned and what its benchmark returned. For example, if a stock fund returned 12 percent and returned 10 percent, the alpha would be 2 percent.
But alpha should really be used to measure return in excess of what would be expected for a given level of risk. If the fund manager outperformed an index, it may have been because the fund assumed more risk than that of the index.
To figure the expected return for an investment’s level of risk, analysts use beta, which measures an asset’s volatility and can be used to gauge risk. If a stock has a beta of 1.2, it might be considered 20 percent riskier than the benchmark and therefore should compensate investors with a higher expected return. If the index returned 10 percent, the stock should return 12 percent. If instead, the stock returned 14 percent, the additional 2 percent would be considered alpha.
Examples of alpha
Alpha is most often used in the fund industry to measure a portfolio manager’s skill, especially for hedge funds and others looking to outperform an index. Generating alpha is the goal of active fund managers because they’re earning returns above what would be expected for a given level of risk-taking.
A fund manager may generate alpha over any time horizon, but it’s most valuable when it’s generated consistently over long periods. Warren Buffett’s company Berkshire Hathaway (BRK.B) has outperformed the S&P 500 by nearly 10 percent annually since 1965. This means that a $1,000 investment in the S&P 500 at the beginning of 1965 would have been worth about $308,000 at the end of 2023, whereas the same investment in Berkshire would have been worth about $42.5 million. That’s a lot of alpha.
What is beta in investing?
Beta, or the beta coefficient, measures volatility relative to the market and can be used as a risk measure. By definition, the market always has a beta of 1, so betas above 1 are considered more volatile than the market, while betas below 1 are considered less volatile.
How to calculate beta
Beta is calculated by taking the covariance between the return of an asset and the return of the market and dividing it by the variance of the market. The measure is backward-looking because you’re using historical data in the calculation of beta. Beta may or may not be a useful measure on a go-forward basis.
Fortunately, you won’t have to calculate the beta for each stock you’re looking at. The beta for any stock can be found on most popular financial websites or through your online broker.
Examples of beta
Here are three popular securities and their betas as of April 16, 2024.
- Vanguard 500 Index Fund (VOO) – 1.00
- Tesla (TSLA) – 2.44
- Walmart (WMT) – 0.49
Different investors might be interested in each of those investments for different reasons. A passive investor looking to earn the market return might choose the Vanguard index fund, while a more aggressive investor who is comfortable with higher levels of risk might select Tesla. Conservative investors looking for stability might select Walmart because of its low expected volatility.
Differences between alpha and beta
Though both greek letters, alpha and beta are quite different from each other. Alpha is a way to measure excess return, while beta is used to measure the volatility, or risk, of an asset.
Beta might also be referred to as the return you can earn by passively owning the market. You can’t earn alpha by investing in a benchmark index fund such as an , which is the definition of beta.
Bottom line
While alpha and beta might sound like complex and intimidating financial terms, they’re really just ways to measure risk and return. While both measures might be considered before making an investment, it is important to remember that they’re backward-looking. Historical alpha isn’t a guarantee of future results and an asset’s volatility can fluctuate from one day to the next.
FAQs
Alpha is a way to measure excess return, while beta is used to measure the volatility, or risk, of an asset. Beta might also be referred to as the return you can earn by passively owning the market.
What is the difference between alpha and beta in investing? ›
Both alpha and beta are historical measures of past performances. Alpha shows how well (or badly) a stock has performed in comparison to a benchmark index. Beta indicates how volatile a stock's price has been in comparison to the market as a whole.
What does alpha tell you in investing? ›
Alpha (α) is a term used in investing to describe an investment strategy's ability to beat the market, or its “edge.” Alpha is thus also often referred to as excess return or the abnormal rate of return in relation to a benchmark, when adjusted for risk.
What is a good alpha for a stock? ›
Alpha is also a measure of risk. An alpha of -15 means the investment was far too risky given the return. An alpha of zero suggests that an asset has earned a return commensurate with the risk. Alpha of greater than zero means an investment outperformed, after adjusting for volatility.
What does beta mean in investing? ›
Beta (β) is a measure of the volatility—or systematic risk—of a security or portfolio compared to the market as a whole (usually the S&P 500). Stocks with betas higher than 1.0 can be interpreted as more volatile than the S&P 500.
What is a good beta for a stock? ›
A beta of 1 indicates that a stock's volatility is in line with the overall market. This can be seen as a neutral or average level of risk. Stocks with betas less than 1 are generally considered less risky than the market, while stocks with betas greater than 1 are generally considered more risky.
Is a higher alpha better in stocks? ›
Alpha values are typically used to rank the performance of actively-managed mutual funds and their investment managers. A higher alpha shows that a particular fund often outperforms the market. You can also use alpha values to check the performance of a particular security against the benchmark index.
Is a negative alpha good? ›
A positive alpha indicates the security is outperforming the market. Conversely, a negative alpha indicates the security fails to generate returns at the same rate as the broader sector. So, according to this definition, a stock with a negative alpha is underperforming.
Is a high alpha good? ›
In general, a higher alpha is more desirable for investors since it means greater return on investment. A lower alpha indicates the fund earned below the average expected for its risk level.
Do you want a high or low alpha? ›
the lower the α , the lower the power; the higher the α, the higher the power. the lower the α , the less likely it is that you will make a Type I Error (i.e. reject the null when it's true). the lower the α , the more “rigorous” the test.
In effect, alpha/beta ratio indicates how resistant a cell is to radiation damage. High alpha/beta ratios (around 10) indicate that single hit damage does not readily accumulate to lethal effects and there is little increase in cell killing per unit dose for higher total doses.
Is an alpha of 5 good? ›
A positive alpha of 5 (+5) means that the portfolio's return exceeded the benchmark index's performance by 5%. An alpha of negative 5 (-5) indicates that the portfolio underperformed the benchmark index by 5%.
Is beta better than alpha? ›
While alpha focuses on relative performance, beta measures risk, specifically how volatile an investment is compared to a market benchmark. A benchmark's beta is always 1.0. An investment with a beta of 2.0 is twice as volatile as the benchmark, while an investment with a beta of 0.75 is 25% less volatile.
What is a bad beta in stocks? ›
Key Takeaways. Beta indicates how volatile a stock's price is in comparison to the overall stock market. A beta greater than 1 indicates a stock's price swings more wildly (i.e., more volatile) than the overall market. A beta of less than 1 indicates that a stock's price is less volatile than the overall market.
Is higher or lower beta better? ›
Beta is a concept that measures the expected move in a stock relative to movements in the overall market. A beta greater than 1.0 suggests that the stock is more volatile than the broader market, and a beta less than 1.0 indicates a stock with lower volatility.
Do you want a higher or lower beta? ›
Investors use beta to align their portfolios with their risk tolerance levels, targeting high-beta stocks for potentially higher returns with more risk, or low-beta stocks for added stability.
What is alpha and beta relationship in stock market? ›
Alpha represents how much an investment's actual return exceeded its expected return, based on its risk level. Alpha is used to evaluate whether an investment outperformed a certain benchmark. Beta, on the other hand, measures how volatile an asset is compared to the overall market.
What does high beta mean in investing? ›
A high beta index refers to a market index that is made up of stocks with higher-than-average volatility as compared to the overall stock market. Some investors aim to maximize returns on investment by investing in high beta stocks, especially during periods when the overall stock market is extremely bullish.
What does a negative alpha mean in investing? ›
A positive alpha indicates the security is outperforming the market. Conversely, a negative alpha indicates the security fails to generate returns at the same rate as the broader sector. So, according to this definition, a stock with a negative alpha is underperforming.
