Everyone of us must have come across the term Alpha & Beta in market commentaries by experts on various business channels and pink sheets, so what is Alpha? and what is Beta? In this blog I'll try to explain it in easy to comprehend manner.
Every investment involves two important aspects – returns and risk. And every investor wants to get the maximum returns with minimum risk. Technically both Alpha & Beta help in measuring risk v/s rewards of investments. There is a difference between Alpha & Beta, Alpha relates to factors affecting the performance of an individual stock (Performance of an individual stock vis a vis the index) while Beta relates to the market momentum (Its based on volatility & swings).
Alpha is the risk-adjusted return on an investment. It is excess return of a stock portfolio or fund over a given benchmark, For example, an 6% return on an investment (Stock or MF) is impressive when equity markets as a whole are returning 2%, but it is far less impressive when other stocks are earning 12%.
- If Alpha=1.0 it means the fund or stock has outperformed its benchmark index by 1 percent.
- If Alpha=(-1.0) it indicates an under-performance of 1 percent.
- If Alpha = 0 it is indicative of investment moving in line with the general market.
For Alpha "0" is the baseline number (more than 0 means out-perfromance & less than 0 means under-performance)
Fund managers are usualy ranked on the basis of how much Alpha their fund generates. It is thus a measure of the fund manager’s ability to generate profits more than the avg market returns.
Beta is a measure of a volatility of a stock and it compares the volatility of stock with the movement of market or benchmark over a period of time.
- A beta of less than 1 means that the stock will be less volatile than the market.
- A beta of greater than 1 indicates that the stock will be more volatile than the market.
- If Beta = 1 it means security’s price will move in sync with the market.
So for beta "1" is the baseline number (more than 1 means higher volatility & less than 1 means lower volatility)
High-beta stocks are generally riskier being more volatile but provide a potential for higher returns as these are in the early stages of growth. On other side low-beta stocks pose less risk and hence lower returns.
As a thumb rule can be said that low beta and high alpha stocks are good. But do not blindly follow Alpha & Beta ratios as both these ratios are looking backward (i.e calculated based on past data), and as we all know from the famous fine line in all documents which we sign: "Past performance is no indicator of future performance".