What’s the Difference Between Alpha and Beta?

Overview of Alpha vs. Beta

Alpha and beta are two of the most important metrics for assessing a company’s performance, funds, or investment portfolio. When compared to a market index or other broad benchmark, an investment’s performance is measured by its alpha or relative return.

The relative unpredictability of an investment is measured by beta. It serves as a cue to the immediate danger. Along with standard error, R-squared, the Sharpe ratio, alpha, and beta are traditional statistics used to assess the returns of an investment portfolio.

Alpha

A single number, such as 3 or -5, serves as the alpha value for a given stock. The figure, however, truly represents the percentage that the stock price or fund price rose or fell about a benchmark index. In this instance, the stock or fund performed 3% best and 5% worse than the index. An investment with an alpha of 1.0 beat its benchmark index by 1%. An investment with an alpha of -1.0 underperformed its benchmark index by 1%. The result met the benchmark if the alpha was zero.

Alpha is a past number; keep this in mind. A stock’s alpha may be followed through time to see how it performed, but it cannot predict how it will perform in the future.

Portfolio Managers’ Alpha

Alpha is a tool that helps individual investors understand how a company or fund could perform in comparison to its competitors or the market at large. The rate of return greater than or less than the projection made by the model is how professional portfolio managers determine alpha. To forecast the probable returns of a portfolio of investments, they employ a capital asset pricing model (CAPM).

That sets a higher standard generally. If the CAPM analysis shows that the portfolio should have earned 5% but only managed to earn 3% due to risk, the state of the economy, and other reasons, the portfolio’s alpha would be a depressing -2%.

To balance risk, portfolio managers diversify their holdings to increase alpha. The value that a portfolio manager contributes or subtracts from a fund’s return is represented by alpha, which measures a portfolio’s performance with a benchmark. The benchmark value for alpha is zero, meaning that the portfolio or fund mirrors the benchmark index exactly. The investment manager has neither gained nor lost any weight in this situation.

Beta

Beta, often known as the beta coefficient, is a measure of a stock’s, a fund’s, or a stock portfolio’s volatility relative to the market as a whole. The proxy gauge for the market is a benchmark index, most frequently the S&P 500. Investors may assess if a stock is worth the danger by understanding its price volatility.

One is the default value for beta, meaning that the associated price moves in lockstep with market trends. A security’s price is less volatile than the market if its beta is less than 1, and the opposite is true if its beta is more significant than 1.

A stock is regarded as 50% more volatile than the market if its beta value is 1.5. Beta is also a historical number, just an alpha.

Examples of Beta

The betas for three well-known equities as of November 2021 are as follows:

MU: 1.27 Micron Technology Inc.

Company Name Coca-Cola (KO): 0.64

SPDR S&P 500 ETY (SPY)

We can observe that Coca-Cola had been 36% less volatile than the whole market, but Micron remained 27% more volatile. Since this ETF follows the S&P 500 index, the SPDRs, or SPYs, get a beta of 1.00. Acceptable betas differ between businesses and industries. Many Nasdaq-listed high-tech stocks have betas of more than 1, whereas many utility firms have less than 1. This indicates to investors that utility companies are dependable earners, whereas tech equities have the potential for more significant returns but typically carry higher risks. While a positive alpha has always been preferable to a negative alpha, the situation with beta could be more complex—lower beta appeals to risk-averse investors, including seniors looking for a consistent income. Higher beta equities are frequently acceptable to risk-tolerant investors looking for greater returns.