Investment alpha and beta: What does it mean?

David P. Angeline, BridgeTower Media Newswires

In every investment there is always some form of risk. It can range from interest rate risk, business risk, liquidity risk or market risk. To measure the amount of risk in an investment there are five key risk measures: alpha, beta, R-squared, standard deviation and Sharpe ratio. These five measures can be used together or individually but as an investor it is essential to know the value of each risk measure. For this article we will only be focusing on alpha and beta.

To help explain beta, here is the exact explanation as described by Investopedia:

“Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. A beta of 1 indicates that the security’s price moves with the market. A beta of less than 1 means that the security is theoretically less volatile than the market. A beta of greater than 1 indicates that the security’s price is theoretically more volatile than the market.”

To better understand beta, let’s look at two hypothetical stocks: Stock A has a beta of 1.15 and Stock B has a beta of 0.90. Since Stock A has a beta above 1 (1.15), it is taking 15% more risk than the market and in theory should have more volatility than the market. Conversely, with Stock B having a beta below 1 (0.90), it is taking 10% less risk and should result in a less volatile investment than the market.

To summarize risk, here is a great quote made by Elroy Dimson, a professor at the London Business School: “Risk means more things can happen than will happen.”

Now to help explain alpha, here is the exact explanation as described by Investopedia:

“Alpha is often used in conjunction with beta and is used as a measure of performance. Alpha, often considered the active return on an investment, gauges the performance of an investment against a market index or benchmark which is considered to represent the market’s movement as a whole. The excess return of an investment relative to the return of a benchmark index is the investment’s alpha.”

To simplify, alpha is the investments return generated on top of the investments benchmark. It is indicated as a single number representing a percentage of how the investment performed. For example, Stock A has an alpha of -4 and Stock B has and alpha of 2. Meaning, Stock A did 4% worse than its benchmark and Stock B did 2% better than its benchmark.

The reason why it is important to understand alpha and beta is due to the fact as an investor you need to understand the risk/reward benefit. You might think your investment is taking less risk than its benchmark but until you compare the beta of your investment to its benchmark you do not fully know. When you look at an investment’s alpha you want to make sure you are being rewarded for the amount of risk you are taking; if you have a negative alpha and beta above 1, you are taking too much risk without any reward. The ideal scenario is a beta below 1 and a positive alpha, which means you are taking less risk than the market but also providing an excess return.

When looking at an investment’s alpha and beta, it’s recommended to look back a minimum of 10 years. Reviewing how a manager has performed in both up markets and down markets aids in deciphering skill from luck.

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David P. Angeline is a vice president at Karpus Investment Management, a local independent, registered investment advisor managing assets for individuals, corporations, non-profits and trustees. Offices are located at 183 Sully’s Trail, Pittsford, NY 14534 (585-586-4680).