Alpha and beta are two terms commonly used in investing. They sound complicated, but they are 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 that is higher than would be expected based on the level of risk. It is also sometimes used as a simple benchmark to determine 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 that alpha is the difference between what an asset has returned and what the benchmark has returned. For example, if a stock fund returned 12 percent and the S&P 500 returned 10 percent, the alpha would be 2 percent.
But alpha should really be used to measure returns that exceed what would be expected at a given level of risk. If the fund manager outperformed an index, it may be because the fund took on more risk than that of the index.
To calculate the expected return for an investment’s risk level, 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 can be considered 20 percent riskier than the benchmark and should therefore compensate investors with a higher expected return. If the index returned 10 percent, the stock should return 12 percent. If the stock returned 14 percent instead, the extra 2 percent would be considered alpha.
Examples of alpha
Alpha is most commonly used in the fund industry to measure a portfolio manager’s skills, especially for hedge funds and other funds that seek to outperform an index. Generating alpha is the goal of active fund managers, as they achieve returns that are higher than would be expected at a given level of risk.
A fund manager can generate alpha over any time horizon, but it is most valuable when it is generated consistently over long periods of time. Warren Buffett’s Berkshire Hathaway (BRK.B) company 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 in early 1965 would have been worth about $308,000 by the end of 2023. while 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 measure of risk. 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 an asset’s return and the market’s return and dividing it by the market’s variance. The measurement is retrospective because you use historical data when calculating beta. Beta may or may not be a useful measure when it comes to the future.
Fortunately, you don’t have to calculate the beta for every stock you look at. The beta for each stock can be found on the most popular financial websites or through your online broker.
Examples of beta
Here are three popular effects and their betas as of April 16, 2024.
- Vanguard 500 Index Fund (VOO) – 1.00 am
- Tesla (TSLA) – 2.44
- Walmart (WMT) – 0.49
Different investors may be interested in each of these investments for different reasons. A passive investor looking for market returns might choose the Vanguard index fund, while a more aggressive investor comfortable with higher levels of risk might choose Tesla. Conservative investors looking for stability might choose Walmart for its low expected volatility.
Differences between alpha and beta
Although 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 can also be referred to as the return you can earn by passively owning the market. You cannot earn alpha by investing in a benchmark index fund such as an S&P 500 index fund, which is the definition of beta.
In short
While alpha and beta may seem complex and intimidating financial terms, they are really just ways of measuring risk and return. While both measures can be considered before making an investment, it is important to remember that they are backward-looking. Historical alpha is not a guarantee of future results and an asset’s volatility can fluctuate from one day to the next.
