One of the key considerations in investing is risk. Over time, your risk tolerance is likely to change, which means that your strategy will also shift. As you determine your risk tolerance and consider how to mitigate the risk currently present in your portfolio, you can use various tools to gather the information necessary for this process.
Two statistical tools that can be especially important in the evaluation of risk are alpha and beta. If you understand these tools and their application, you can make more informed investment decisions and increase the chances of realizing a positive return—or at least protecting the nest egg you have already built.
While many other statistical tools exist, alpha and beta are some of the values that investors study as they hunt for new opportunities. Here’s what you need to know:
Alpha and Beta – the Basics
Both alpha and beta are calculated using the historic performance of the asset in question and comparing it to a particular index. However, the two calculations analyze different things. Alpha looks at the returns the asset has generated compared to the index, while beta helps measure the volatility of an equity.
Typically, alpha and beta use a benchmark index like the S&P 500, but it is important to know which specific index was chosen, since this affects the interpretation. Generally, investors use alpha to evaluate mutual funds; measuring their performance in relation to the S&P 500 can tell you if funds are over- or under-performing. Beta measures volatility and is usually used to measure risk. A higher beta indicates greater risk.
To calculate alpha, you subtract the return on investment of a specific index from the same return of a mutual fund. A positive alpha means that the fund has historically performed better than the index, while a negative alpha indicates underperformance. If the alpha is zero, the mutual fund performs identically to the chosen index.
Alpha is expressed as a whole number, but it actually represents a percentage. For example, an alpha of 5 indicates performance 5 percent higher than the index, while -5 indicates performance 5 percent lower than the index after volatility has been accounted for. This percent can mean radically different things depending on the overall value of the asset and index.
The calculation of beta generates a ratio. A beta greater than one indicates the asset is more volatile than the index to which it is being compared. For example, a beta of 1.2 tells you that the investment is 20 percent more volatile than the index. A beta less than zero indicates lower volatility in comparison to the index. If the beta is 1.0, then the asset and the index have the same volatility.
How to Use Alpha and Beta When Making Investment Decisions
Alpha and beta help you answer some of the questions that you may have as you decide on investments. For example, if you only want to consider mutual funds that have outperformed the stock market, you can narrow your search to those with a positive alpha.
You should look up the alpha of the investment in question as well as that of a relevant comparison index, such as the S&P 500. The difference between these numbers can help you rank investments based on their performance. However, you need to remember that high performance often goes hand-in-hand with high volatility. Thus, the risk of these investments might prove quite high. This is where beta can enhance your analysis; choosing only the investments that perform above an index can expose you to excessive risk.
People who want to minimize their risk exposure depend heavily on beta. Comparing the beta of different investments can help you understand the relative risk of each. This number can help you ensure that the risk of your portfolio aligns with your tolerance, especially as that tolerance changes over time.
Almost always, investors consider beta in the context of alpha and vice versa. Having both values can help you judge the relationship between risk and return for a particular investment. Importantly, both high and low beta can lead to market outperformance. Imagine a mutual fund weighted towards growth stocks. This fund likely has high beta and may outperform the market to get high alpha. However, a conservative fund with only bonds may also outperform the market, yet have a very low beta.
When considering alpha and beta, it is also important to keep in mind that these calculations are based on historical performance. These numbers do not guarantee that the investments will act similarly in the future. Furthermore, alpha and beta calculations largely depend on the comparison index used.
Always make sure you understand how the calculations were done and determine whether the choices were appropriate. Choosing a market that is inappropriate can make either number falsely elevated or lowered, so think critically about the comparison given and the validity of the result.